The Philips curve theory held well until the 1970s but after that it was challenged as economies started experiencing high inflation and high unemployment. Milton Friedman and Edmund S Phelps argued that the Philips Curve did not give a true picture of the labor market processes. They thus presented the ‘Expectation Augmented Philips Curve’ (The Inflation Acceleration Controversy, n.d.).
Unemployment is defined as U = (Ls– Ld)/ Ls where Ls is the supply of labor and Ld is the demand for labor. At a particular real wage level households supply labor “according to their utility-maximizing labor-leisure choice combination” (The Inflation Acceleration Controversy, n.d.). Thus the particular amount of labor supplied will be Ls*. Friedman and Phelps natural rate of unemployment U* at a particular real wage could then be defined as U* = (Ls* – Ld)/Ls*.
The “natural” unemployment rate U* includes frictional and structural unemployment while excluding cyclical unemployment. Frictional unemployment includes those who are actively looking for jobs whereas Structural unemployment includes those who are improving their skills to meet the market’s skill requirements. These people were made redundant due to structural changes in their industries. On the other hand Cyclical unemployment includes those who had been made redundant due to insufficient aggregate demand. Natural rate of unemployment can therefore be considered as full employment (The Inflation Acceleration Controversy, n.d.).
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