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.

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