Questions: Natural Rate Hypothesis and NAIRU

Question 1

A central bank pursues sustained expansionary monetary policy to hold unemployment below the NAIRU for several years. After expectations fully adjust, what is the most likely outcome according to the natural rate hypothesis?

• A. Unemployment permanently falls to the new lower level, with inflation stabilizing at a higher rate
• B. Unemployment returns to the NAIRU and inflation returns to its original pre-stimulus level
• C. Unemployment returns to the NAIRU while inflation remains elevated — and will continue accelerating if the policy persists
• D. Unemployment overshoots the NAIRU upward before eventually returning to it

Answer: (C)

The natural rate hypothesis predicts that expansionary policy creates only a temporary reduction in unemployment. As workers and firms form expectations of higher inflation, they adjust wages and prices accordingly. The short-run Phillips curve shifts upward, returning unemployment to the NAIRU. Crucially, inflation does not return to its original level — it stays elevated (or accelerates further if the central bank keeps pushing). This is why the hypothesis implies an accelerating inflation spiral if policymakers repeatedly attempt to hold unemployment below the NAIRU: each round of stimulus leaves inflation higher than before.

Question 2

Which of the following policies would the natural rate hypothesis predict could produce a permanent reduction in unemployment?

• A. Sustained expansionary fiscal policy financed by money creation
• B. A central bank commitment to maintain real interest rates below neutral indefinitely
• C. Reducing job search frictions through better employment matching services and retraining programs
• D. A permanent increase in the money supply growth rate

Answer: (C)

The natural rate hypothesis holds that the NAIRU is determined by real structural factors — labor market institutions, search frictions, wage rigidities, demographic composition — not by monetary or fiscal demand management. Only policies that alter these structural determinants can permanently lower the natural rate. Better job matching reduces the time workers spend unemployed between jobs (frictional unemployment), directly lowering structural unemployment. The other options all involve demand-side stimulus, which the hypothesis predicts will produce only temporary effects on unemployment while permanently affecting inflation.

Question 3

According to the natural rate hypothesis, if a central bank persistently attempts to hold unemployment below the NAIRU, the result is not merely higher inflation but continuously accelerating inflation.

• T. True
• F. False

Answer: True

This is the sharp implication of the vertical long-run Phillips curve. If unemployment is held below the NAIRU, labor markets are too tight, wages rise faster than productivity, firms raise prices, inflation rises, and workers demand still higher wages to compensate — a spiral. Each short-run Phillips curve shift leaves the economy at a higher inflation rate, and the next round of stimulus needed to push unemployment below the NAIRU requires generating still more surprise inflation. The result is an accelerating, not merely elevated, inflation rate. This insight, from Friedman's 1968 address, was validated by the stagflation of the 1970s.

Question 4

The natural rate of unemployment is a fixed biological or economic constant that remains the same across most countries and time periods.

• T. True
• F. False

Answer: False

The natural rate varies considerably across countries and changes over time within a single country. It is determined by structural factors — labor market institutions (minimum wages, unionization, unemployment insurance generosity), the efficiency of job matching, workforce demographics, and regulatory environment — all of which differ across economies and evolve over time. For example, European countries with more generous unemployment benefits and stronger job protections have historically had higher natural rates than more flexible labor markets. This is why Friedman called it 'natural' in the sense of being determined by real factors, not monetary ones — not in the sense of being fixed or optimal.

Question 5

Why does the natural rate hypothesis imply that the long-run Phillips curve is vertical, and what does this mean for monetary policy's ability to affect unemployment permanently?

Model answer: The long-run Phillips curve is vertical because, once inflation expectations fully adjust, the economy returns to the NAIRU regardless of the steady-state inflation rate. Any given NAIRU is compatible with 2% inflation, 5% inflation, or 10% inflation — the unemployment rate is the same. Graphically, this is a vertical line at the NAIRU. Monetary policy can choose which point on the vertical line to be at (which inflation rate) but cannot shift unemployment left or right of it in the long run. Only supply-side structural reforms that lower the NAIRU itself can achieve permanent reductions in unemployment.

The intuition is about expectations. Any monetary expansion that reduces unemployment works by creating unexpected inflation — surprising workers and firms who set wages and prices based on past inflation. Once expectations adapt, the surprise is gone, the policy loses its effect, and unemployment returns to the NAIRU. To keep unemployment below the NAIRU would require continuously surprising the economy with ever-higher inflation — the accelerating spiral. A monetary authority that truly accepts the natural rate hypothesis will focus on stabilizing inflation expectations rather than chasing unemployment targets below the structural floor.