On Drawing the Wrong Lessons from Theory: The Natural Rate of Unemployment

Economic theory is important. Theory provides discipline. Economists write down a set of assumptions and follow those assumptions to their logical conclusions. The validity of a particular theory is then tested against observed data. Modern economic theory is often mathematical, but theory comes in a variety of forms. Sometimes theory is used to develop and test specific empirical predictions. Other times, economic theory acts as a type of sophisticated thought experiment. These thought experiments generate broader empirical predictions. In fact, some of these sophisticated thought experiments contain important lessons for monetary policy.

In the late 1960s, Milton Friedman suggested that monetary policy was limited in its ability to influence the unemployment rate. Friedman argued this point by discussing the concept of a natural rate of unemployment. The idea is that there is some unemployment rate that would exist in the economy based on the fundamentals of the economy. If the unemployment rate is equal to the natural rate, the central bank cannot permanently reduce the unemployment rate. The only way in which the central bank can lower the unemployment rate is by producing higher than expected inflation. The temporary decline in real wages would lead to an increase in output and lower unemployment. Ultimately, real wages rise and employment returns to its original level.

The theory proposed by Friedman is very much in the thought experiment variety. If we accept the idea of a natural rate of unemployment pinned down by real factors, then nominal changes will not have any long-run effect on the unemployment rate. This conclusion is a version of what economists call the classical dichotomy – the idea that nominal variables only affect other nominal variables in the long-run and real factors determine resource allocation.

Subsequent economists explored this concept of the natural rate of unemployment. Finn Kydland and Ed Prescott developed a model to consider what would happen if a discretionary central bank had a lower target for the unemployment rate than the natural rate. What they found is that, in equilibrium, the unemployment rate would equal its natural rate, but the rate of inflation would be higher than if their target for the unemployment rate was equal to the natural rate.

This sort of sophisticated thought experiment contains important lessons for monetary policy. For example, what the model shows is that a preference for unemployment to be lower than its natural rate does not allow discretionary policymakers to achieve this lower rate in equilibrium. Instead, the economy will always end up at the natural rate. Discretion will only lead to higher inflation. The broad lesson is that rules-based policy is better than discretionary policy because a rule would avoid this tendency to try to manipulate the unemployment rate.

Friedman’s concept of a natural rate of unemployment was inspired by Knut Wicksell’s natural rate of interest. According to Wicksell, the natural rate of interest is pinned down by the marginal productivity of capital in the economy. When the market interest rate is below the natural rate, this leads to an expansion of money and credit and therefore inflation rises. When the market interest rate is above the natural rate, money and credit contract and inflation declines. Both of these concepts – the natural rate of unemployment and the natural rate of interest – continue to play a role in the way that policy is discussed and conducted.

While the sophisticated thought experiments that draw upon these concepts contain important lessons for policy, it is important to remember that they are thought experiments. In reality, there is no empirically observable natural rate of unemployment nor a natural rate of interest. These are theoretical concepts used to motivate the thought experiment.

Economists, however, seem to have drawn the wrong lesson from such thought experiments. Since policy is neutral when the market interest rate is equal to its natural rate or when the unemployment rate is equal to its natural rate, economists have sought to estimate these natural rates. This is a problem because these are theoretical constructs. Estimates of these natural rates cannot be compared to some observable counterpart to assess their goodness of fit. Estimation often requires the use of some sort of structural model. The extent to which the estimate is useful depends on the external validity of the model.

This is worrisome because references to the natural rate of unemployment or the natural rate of interest have become more common among policymakers. The Federal Reserve consistently refers to purported inflationary “pressures” that come from declining rates of unemployment (which, by the way, reverses the direction of causation described by Friedman).

Rather than judging the stance of monetary policy by the proximity of the unemployment rate or the interest rate to their respective natural rates, central banks should rely on an explicit target of a measureable macroeconomic variable that the central bank can directly influence with policy. With an explicit target, there is no need to estimate the natural rate of interest or natural rate of unemployment. For example, suppose the central bank targeted a five percent growth rate for nominal income in the economy. If nominal income growth is higher than five percent, this indicates that policy is too expansionary. If nominal income growth is below five percent, then monetary policy is too contractionary. When nominal income growth is approximately equal to its target, policy is neutral. There is no need to estimate any natural rate.

The Federal Reserve’s dual mandate of stable prices and maximum employment is partly to blame for the emphasis on the unemployment rate and attempts to estimate a natural rate. However, an explicit target would provide a sense of neutral monetary policy in a much more straightforward and easily observable way. In addition, achieving maximum employment need not require explicitly targeting the unemployment rate or some other measure of employment. The objective of the central bank should be to achieve nominal stability, such as the stability of the growth of nominal income. With nominal stability, relative prices will adjust to allocate resources to their most productive use. This is the main lesson of Friedman’s thought experiment. Attempts to estimate a natural rate of unemployment draw the wrong lesson. Such estimates are an unwelcome diversion pursued under the guise of being scientific.