Please explain the beliefs of both the New Classical Theory and Milton Friedmans Natural Rate Hypothesis.

Milton Friedman’s Natural Rate theory was developed in response to the Phillips curve. The Phillips curve established a relationship between inflation and the rate of unemployment. The theory suggested that a rise in price inflation that is yet to be perceived by the employer would lead to an increase in the rate of employment. This is because the employer would view the increase in prices as an increase in demand, which would force the employer...

Milton Friedman’s Natural Rate theory was developed in response to the Phillips curve. The Phillips curve established a relationship between inflation and the rate of unemployment. The theory suggested that a rise in price inflation that is yet to be perceived by the employer would lead to an increase in the rate of employment. This is because the employer would view the increase in prices as an increase in demand, which would force the employer to procure more human resources to increase production. The curve also suggests that an increase in wages due to inflation would lead to an increase of labor supply especially when the workers do not anticipate the inflation.

The theory thus determined that monetary policies would generally control the rate of unemployment. However Friedman challenged the theory by suggesting a natural rate of unemployment that would result regardless of changes in the monetary policies. Friedman suggested that the Phillips curve only worked in the short run when the employer and worker did not perceive the inflation. He stated that in the event the employer and worker perceived the inflation, the unemployment rate would be automatically adjusted to the “natural rate”. According to Friedman, this suggests that inflation has no real impact on unemployment.

New classical theory suggests a return to market liberalization and limited interference by the government. In regards to labor markets, the new classical theory supports the establishment of free labor and product markets, where the wages and prices for commodities are set by market forces of demand and supply and not government monetary policies. This in turn supports the theory by Friedman, which states that inflation is not a reliable monetary tool in determining the rate of unemployment within an economy. Nonetheless, one of the three New classical theory approaches to emerge suggests that, while markets are able to generate economic stability between unemployment, inflation and market productivity, government should use microeconomic policy to adjust for imperfections in markets such as markets that fail to emerge or markets that are affected by imperfect knowledge.