Natural Rate Theory

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Overview of The Natural Rate Theory

Early Keynesians believed in setting nominal wages and prices respectively and not taking into account inflationary expectations.

Currently new Keynesians take in to account inflationary expectations therefore setting real wages and prices. These policies result in limiting the affect on unemployment and output.

What happens when only relative wages and prices are set by price and wage setters?

If unemployment rate is below natural level of unemployment there will be accelerated.

And vice versa if it is above then there will be accelerated deflation.

The dynamics of inflation

If unemployment is below the natural rate this will cause…

• Demand for goods and for labor to be high
• Firm decides to charge higher prices than others
• This will cause actual inflation to exceed expected. This gap will cause a further reaction
• Expectations are adjusted upwards and inflation rises higher still. Inflation is ever increasing

The question Akerlof asks is are the wages and prices set are a realistic view of employers and consumers preferences? In other words do employers and consumers think the wages and prices should or should not be set?

The acceptance of the natural rate theory

The fundamental assumption of the natural rate theory is that the economy only cares about the real outcome. Also the natural rate theory is not sensitive to changes from the perfect competitive model.

The Phillips curve The relationship between wage and price would be affected one for one by inflationary expectation

The Phillips curve pre 1970s This curve was derived from about 100 years of data.

The Phillips curve post 1970s In the 1970s due to oil shocks and increase inflationary expectations wage inflation and unemployment rate rose. Natural Rate Theory helped explain the modified/accelerationist Phillips Curve. There is a negative relation between the unemployment rate and the change in the inflation rate. A low unemployment rate leads to an increase in the inflation rate and an increase in price level. put in diagram

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