Of Coconuts, Decomposition and a Jackass: The Genealogy of the Natural Rate

Abstract

The concept of the natural rate of unemployment was formulated in 1968, by Friedman and Phelps. In Friedman, it plays the central role in his theory of the relationship between the short-run and long-run Phillips curve. However, in this chapter I will focus not on its role within the theory of inflation per se, but rather on the fundamental notion of equilibrium, the natural rate itself. The natural rate stands in a tradition of ideas that may be loosely called classical or monetarist. We may well ask, therefore, two questions: first, how does the idea of the natural rate (NR) differ from its predecessors; secondly, how have more recent ideas developed or diverged from it? A full and proper answer to both of these questions would require a degree of scholarship and comprehensive grasp of the broad sweep of the history of economic thought which, alas, eludes me. However, I intend to approach both questions in terms of a series of snapshots and observations which will be drawn together towards the end of the chapter. Without spoiling the story, I conclude that the natural rate as an equilibrium concept was largely derivative of Patinkin’s concept of full employment, as laid out in his Money, Interest and Prices (first published in 1956). However, Friedman nowhere ever lays down a specific theory of the natural rate itself, and as such the concept has proven sufficiently loose and vague to fit a variety of subsequent models of equilibrium.