Natural-Rate Hypothesis

Published Jan 8, 2023

Definition of Natural-Rate Hypothesis

The natural-rate hypothesis (NRH) is an economic theory that states that the unemployment rate in an economy will eventually return to its natural rate, regardless of the level of economic activity. That means it describes the rate of unemployment that exists when the labor market is in equilibrium. This rate is determined by the structure and dynamics of the labor market and is independent of the level of aggregate demand.

Example

To illustrate the natural-rate hypothesis, let’s look at the economy of a small imaginary country. In this country, the natural rate of unemployment is 5%. That means when the economy is in equilibrium, the unemployment rate will be 5%. Now, assume the government decides to stimulate the economy by increasing aggregate demand. As a result, the unemployment rate drops to 3%. However, according to the NRH, this decrease in unemployment is only temporary. Eventually, the unemployment rate will return to its natural rate of 5%.

Why Natural-Rate Hypothesis Matters

The natural-rate hypothesis is an important concept in macroeconomics. It helps economists to understand the dynamics of the labor market and the effects of government policies on unemployment. In addition to that, it is also used to evaluate the effectiveness of government policies. That is, if the government implements a policy to reduce unemployment, but the unemployment rate does not decrease, then it is likely that the policy has not been effective.