Natural Rate Theory

Overview of The Natural Rate Theory

Early Keynesians believed in setting nominal wages and prices respectively and not taking into account inflationary expectations. New Keynesians now take in to account inflationary expectations, therefore setting real wages and prices. These policies result in limiting the effect 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 increase
• Firms will decide 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 if 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.

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. After the 70s the Phillips curve shows 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.

Inconsistencies in the Natural Rate Theory

Nominal considerations AFFECT wage setting

1. Nominal wage rigidity. Money wages are downwardly rigid because many wages and prices are set in nominal terms for some time and are not readjusted when there is a change in policy. There is no way to account for nominal rigidity with the present model for natural rate because of the assumption that people in the economy only care about real prices and wages.

2. Different perspective of money wage rigidity. Thomas Bewley researched firms and discovered that employers are reluctant to cut wages because of the negative effect on morale. Workers would shirk and in some cases most likely quit. Once again this worker and employer behavior fails to conform to the natural rate theory assumptions. Workers are not only thinking about their wages relative to price level and to wages received by others but dislike cuts to their wages below the nominal levels.

3. The Great Depression. The new Phillips Curve (accelerationist) would say that during the time of the Great Depression from 1930 to 1940 inflation should have been below the inflationary expectations. “The data revealed no evidence whatever in any country of constantly declining inflation, even under conditions of massive unemployment”. “Sticky-money” wages model explains the occurrences during the Great Depression.

4. Wage bargains are not made with only real considerations in mind. For example consider two professors Professor McPhail and Professor Farrant. They both take their first job at Dickinson College and have the same initial income. Who will be better off, Professor McPhail who receives a 5% raise in the presence of 4% of inflation or Professor Farrant who receives a 2% raise when inflation is zero?

• One must consider something called the happiness factor. Even though Professor Farrant profits more from the raise, Professor McPhail will be happier and has a higher utility.

• In contradiction to the assumptions of natural rate theory, people’s happiness is affected by their nominal wage increase and not just their real wage.

• In support of this argument, Robert Shiller an economist found that about half of the general public agreed with this statement, “if my pay went up I would feel more satisfaction in my job, more sense of fulfillment, even if prices went up as much”.

• Bias between the public and professional economists. Economists believe people should be only concerned with their real wages however seen in these examples this is not the case. The lack of the accordance between the public and economists is another reason why the natural rate theory is flawed.

5. The absence of wage indexation in union contracts.

• Natural rate theorists contend that throughout the bargaining process, agents first agree upon a real wage in current prices and then add inflationary expecations. From this theory, it would follow that "firms and workers with risk aversion will both have their welfare improved by contracts with wages indexed to inflation" (Akerlof 34).

• On the contrary, studies have shown that the majority of contracts are incompletely indexed. Christofides and Peng (2004) examined a sample of 12,000 Canadian union contracts from 1976 to 2000, which had a mean length of 25 months. Only 19 percent of these contracts were indexed. In addition, only 58 percent of these contracts fully covered price increases.

• This points to another anomaly of wage indexation. In many contracts, wages are only adjusted if inflation passes a certain trigger level. This provison does not seem to follow from the fact that agents are solely concerned with real variables.

6. Not all Phillips Curve estimates produce coefficients of unity on lagged inflation.

• William Brainard and George Perry made estimates of Phillips Curves wherein the lag coefficients did not some to unity, as natural rate theory would predict.

• Economists have uncovered systematic differences between times when the coefficients sum to unity and times when the sum of lag coefficients is considerably less than one. William Dickens, George Perry, and George Akelof (2000) estimated Phillips Curves in the US during high and low inflationary periods. They discovered that in high inflationary periods, the sum of coefficients on lagged inflation in wage and price equations approaches one. In contrast, in low inflationary periods, the sum on wage equations is close to zero and the sum on price equations in greater than zero but considerably less than one.

• Estimates of Phillips Curves with direct measures of expecations generate similar results wherein the sum of lagged inflation in wage equations averages .3 and sum in price equations averages .6.

• "These findings question the universality of Phillips Curves with coefficients of one on proxies for expected inflation."

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