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Milton Friedman's Natural Rate Hypothesis and Its Impact on Economic Theory and

Policy

Rajan Gill

San Jośe State University

ECON 191 - Economic Thought of Nobel Prize Winners

Professor Kevin Chiu

28th June 2024

Milton Friedman’s Natural Rate Hypothesis basically revolutionized macroeconomic

theory and policy. The "natural rate" theory, first presented in his 1968 Presidential Address to

the American Economic Association, suggests that the economy inherently tends to a particular

level of unemployment (Friedman, 1995). According to Friedman, when inflation occurs without

a demand gap, the presence of fiscal policy can push the economy past the long-run aggregate

supply (LRAS). However, the rise in inflation leads to adjustments in the short-run aggregate

supply (SRAS), resulting in a situation where, over the long term, the real gross domestic

product (GDP) remains unchanged, but price levels increase. This mechanism illustrates why the

Phillips Curve, which proposed a consistent trade-off between inflation and unemployment, is

valid only in the short term prior to the SRAS adjustment. By highlighting the role of

expectations, Friedman established the foundation for the rational expectations revolution in

macroeconomics, redirecting policy discussions from short-term trade-offs to long-term stability

(Kydland & Prescott, 1977).

Prior to Friedman’s hypothesis, the existing Keynesian view speculated a stable inverse

relationship between inflation and unemployment, as portrayed by the Phillips Curve. However,

the phenomenon of stagflation in the 1970s—marked by high inflation and high unemployment

—challenged this view (Mundell, 2000). According to Friedman, while monetary policy can help

lower unemployment below the natural rate, such a situation cannot be sustained without causing

escalating inflation. This insight was helpful especially in understanding the flaws of using

monetary policy to manage the business cycle. Edmund Phelps later refined this concept through

the addition of microeconomic aspects into the analysis of labor markets and expectation

(Phelps, 1967). Phelps, along with Friedman, promoted the idea that rational expectations are

significantly involved in the overall economic performance, altering the foundation of the
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macroeconomic and monetary policies. This new understanding pushed central banks to employ

policies that are directed towards managing expectations of inflation instead of directly

influencing short-term economic operations (Taylor, 1993).

The significance of the Natural Rate Hypothesis goes beyond just academic economics

because it affects people’s lives in a major way. Notably, Friedman revealed the dangers of

overly aggressive monetary policies by arguing that trying to keep unemployment below the

natural rate would accelerate inflation (Nelson, 2020). This idea helped central banks come up

with strategies that would prevent high levels of inflation, which disproportionately affects

lower-income households and savers. Many central banks started adopting inflation targeting as

a way of directly applying Friedman’s principles to achieve stable inflation expectations and

economic stability. Furthermore, the hypothesis emphasizes the significance of structural policies

such as labor market changes and education in reducing unemployment permanently. Thus, both

monetary and fiscal policies have been following the Natural Rate Hypothesis to enable creation

of a more sustainable and prosperous economy (Blanchard, 2018).

There is a lot of empirical evidence in favor of the natural rate hypothesis, especially in

relation to inflation dynamics and labor market behavior. For example, the Volcker disinflation

of the early 1980s in the United States showed how important it is for monetary policy to be

credible enough to anchor inflation expectations. The Federal Reserve’s Chairman at that time,

Paul Volcker, used tight money policies to control high inflation rates in the 1970s (Volcker &

Lecture, 1990). This initially caused a significant increase in unemployment but later on, people

adjusted their expectations about inflation hence stabilizing the economy at lower inflation rates

without causing any permanent rise in joblessness. Other developed economies have had similar

experiences, which have proved Friedman’s theory by indicating that long-term unemployment
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is mainly driven by structural factors rather than the aggregate demand management (Federal

Reserve Economic Data, 2024).

Friedman's natural rate hypothesis is something I can relate due to its realistic policy

constraints and expectations. While studying economics, I have learnt that running an economy

is a complicated affair and there are consequences that arise from well- intentioned policies. The

message that can be derived from Friedman’s work is that it is better to avoid easy ways out for

complicated problems, and that policy environments need to be credible and transparent. This

has altered my perspective of macroeconomic policies and the human behavior because of the

emphasis on the long-term perspective when developing policies, instead of following short-term

goals. This hypothesis also points to the need of always remaining ready to learn when

formulating economic policies, although I find this somewhat difficult yet interesting.

In conclusion, the Natural Rate Hypothesis presented by Milton Friedman was

revolutionary in changing the previous outlook of inflation and unemployment in the context of

economic theories and policies. Its development is also considered as a revolution in the

macroeconomic theory as it focuses on the expectations and the limitations of the monetary

policy. It has helped to shape central banking practices and resulted in better societal welfare

through creating more stability in the economy. For economics student, this is a fantastic source

for learning about humility, reality, and reliance on rigorous analysis in policymaking. Friedman

remains one of the most important figures of contemporary macroeconomics whose ideas

continue shaping discussions about policies aimed at ensuring sustained prosperity within stable

economies.
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References

Blanchard, O. (2018). Should we reject the natural rate hypothesis?. Journal of Economic

Perspectives, 32(1), 97-120.

Federal Reserve Economic Data (FRED). (2024). Unemployment Rate and Inflation Data.

Retrieved from https://fred.stlouisfed.org/.

Friedman, M. (1995). The role of monetary policy (pp. 215-231). Macmillan Education UK.

Kydland, F. E., & Prescott, E. C. (1977). Rules rather than discretion: The inconsistency of

optimal plans. Journal of political economy, 85(3), 473-491.

Mundell, R. A. (2000). A reconsideration of the twentieth century. American Economic

Review, 90(3), 327-340.

Nelson, E. (2020). Seven fallacies concerning Milton Friedman's “The role of monetary policy”.

Journal of Money, Credit and Banking, 52(1), 145-164.

Phelps, E. S. (1967). Phillips curves, expectations of inflation and optimal unemployment over

time. Economica, 254-281.

Taylor, J. B. (1993). Discretion versus policy rules in practice. In Carnegie-Rochester

conference series on public policy (Vol. 39, pp. 195-214). North-Holland.

Volcker, P. A., & Lecture, P. J. (1990). The triumph of central banking?. Federal Reserve Bank

of Kansas City.