Productivity Growth and the Natural Rate:

Third in recent years it has turn into more and more likely that a major determinant of the natural rate is the rate of productivity growth. The era of measured productivity growth from the mid-1970s to the mid-1990s saw a relatively high natural rate. By contrast speedy productivity growth before 1973 and after 1975 seems to have generated a low natural rate.

Why must a productivity growth slowdown generate a high natural rate? A higher rate of productivity growth permits firms to pay higher real wage increases and still remain possible. If workers' aspirations for real wage escalation themselves depend on the rate of unemployment then a slowdown in productivity growth will raise the natural rate. If real wages grow sooner than productivity for an extended period of time profits will disappear. Long previous to that point are reached businesses will begin to fire workers and unemployment will rise. Therefore if productivity growth slows unemployment will rise. Unemployment will keep increasing until workers' real wage aspirations fall to a rate consistent with current productivity growth.

Expected Inflation:

The natural rate of unemployment as well as expected inflation together determine the location of the Phillips curve because it passes through the point where inflation is equal to expected inflation and unemployment is equal to its natural rate. Higher expected inflation would shift the Phillips curve upward. However who does the expecting? As well as when do people form expectations relevant for this year's Phillips curve?

Economists work with three fundamental scenarios for how workers, managers and investors go about forecasting the future and forming their expectations:

•    Static expectations. Static expectations of inflation succeed when people ignore the fact that inflation can change.

•    Adaptive expectations. Adaptive expectations succeed when people presume the future will be like the recent past.

•    Rational expectations. Rational expectations prevail when people use all the information they have as best they can.

The Phillips curve behaves extremely differently under each of these three scenarios.

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