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MILTON FRIEDMAN AND THE NATURAL RATE OF UNEMPLOYMENT

"Full employment" does not mean 100 percent employment. For various reasons, the unemployment rate cannot be reduced to zero, if only because people are always being fired, laid off or moving between jobs. But even granting that unemployment can never be completely eliminated, it still might be possible to ensure that anyone searching for a job can find one reasonably quickly. Economists call this happy state of affairs "full employment."

How can it be reached? Early Keynesians believed that they could achieve it by expanding the money supply. Of course they could not overdo it. Keynes himself knew of this danger when he wrote Tract on Monetary Reform in 1923. The central bank could expand the money supply right up to the point where full employment was reached; after that, any monetary expansion would result in inflation. The question was how much to expand.

An apparent answer emerged in 1959, when British economist A.W. Phillips discovered a relationship between wages and unemployment in British historical statistics. When unemployment was high, wages had fallen; when unemployment was low, wages had risen. A look at American statistics revealed the same tradeoff. Since wage changes are indicators of inflation, this discovery actually showed that a tradeoff existed between inflation and unemployment. Accepting more of one meant less of the other. When graphed, this tradeoff produced a nice, neat curve, which became known as the "Phillips Curve."

This discovery helped policy-makers determine how much to expand the money supply. Previously, no one really knew what constituted "full employment." Now they could make a judgment call. The curve showed them how far they could expand the economy without letting the cost of inflation outweigh the cost of unemployment. This seemed to be 3 or 4 percent inflation in return for 4 percent unemployment.


Note the terms the "natural rate of unemployment" and the term "Phillups Curve" from the above excerpt from the article.