Definition
The natural rate hypothesis holds that there is a particular unemployment rate, the natural rate, that the economy gravitates toward in the long run. Attempts to keep unemployment below that rate by stimulating demand work only temporarily, and the cost is rising inflation.
Developed by Milton Friedman and Edmund Phelps, the hypothesis challenged the older view that policymakers could permanently buy lower unemployment with higher inflation. Its key claim is that the long-run trade-off does not exist.
Why it matters
How it works
When policymakers push demand to drive unemployment below the natural rate, inflation rises. At first workers are fooled, because they have not yet revised their expectations. Once they update expectations to match actual inflation, they demand higher wages, and unemployment drifts back to the natural rate.
Holding unemployment down therefore requires inflation that is not just high but accelerating, so that it keeps outrunning expectations. Because that is unsustainable, the only stable long-run outcome is unemployment at its natural rate.