July 19, 2002

The NAIRU: Non-Accelerating Inflation Rate of Unemployment

The NAIRU

A key concept in macroeconomic policy is the idea of the NAIRU: the Non-Accelerating-Inflation Rate of Unemployment, the rate of unemployment at which there is neither upward pressure on inflation (from producers taking advantage of the market power given them by bottlenecks, and from workers using the market power provided by a tight labor market to try to realize wage growth aspirations higher than the rate of productiivty growth) nor downward pressure on inflation (from customers taking advantage of the market power given them by excess capacity, and from firms using the market power provided by high unemployment to try to decrease the rate of wage growth).

If you look at the unemployment rate in the U.S. and the following year's change in inflation, you find that an extra one percentage point of unemployment pushes the inflation rate down by about 0.4 percentage points in the following year--more in some years, less than others, as shown in the figure below.

If we accept this number of 0.4 for what economists call the "Phillips curve slope," we can follow Ball and Mankiw (2002) and calculate the information each year gives us about the NAIRU. Given a year's unemployment rate and the subsequent year-to-year change in inflation that was actually observed, what unemployment rate would have kept inflation stable? The answer--for each year--is simply that year's unemployment rate plus 0.4 times the one-year-ahead change in inflation. The resulting year-by-year NAIRU estimates are plotted in the figure below.

As with all statistical relationships in economics, the relationship between inflation and unemployment is a loose one, not a tight one. All kinds of disturbing factors other than the current rate of unemployment have a secondary influence on the change in inflation. So the year-by-year NAIRU estimates have a lot of noise in them: any and all disturbing factors that influence the rate of inflation add noise to our simple estimate of the NAIRU. To reduce this noise, take a local moving average in the hope that last year's noise will largely cancel out this year's noise. The figure above plots a seven-year moving average: each year's associated smoothed estimate of the NAIRU is the average of the year-by-year estimates from three years in the past to three years in the future.

The purple line in the figure above tells a story of a NAIRU that is relatively variable: in the early 1980s it was above 7%. But in the mid 1960s and today it has reached a trough of 4.5% or so.


*Note that this cannot be said to be a complete or a fully-informed estimate of the NAIRU. A complete estimate would use our theoretical belief that the NAIRU--a structural feature of the economy--should change only slowly, as the structure of the economy changes. A complete estimate would use knowledge of the demographic features of the labor force and of the workings of the labor market to determine how much weight to give to fluctuations in the numbers that might be due just to chance. The principal disadvantage of the series above is that it just tells you what a narrow range of the data say. They again, that is its principal advantage: it tells you what the data say, and so provides a foundation from which you can argue and think about how theory, demography, and structure should be combined with what the aggregate data say.

Posted by DeLong at July 19, 2002 11:39 AM | TrackBack

Comments

This raises a question I've always had about the NAIRU. If it changes as quickly as your figure indicates, and if our knowledge of it lags its changes by several years, can it ever be a useful guide to policy? The concept of a NAIRU seems useful--signs of accelerating inflation when unemployment has recently fallen are probably a useful indicator that it is time for monetary policy tightening. But can the Fed ever usefully adopt a ground rule that it will tighten when unemployment falls below x, and loosen when it rises above y, even if it updates x and y as much as available information permits?

The experience of the late 1990s suggests not. Had Greenspan heeded the conventional wisdom, he would have reigned in the economy when unemployment fell below 6.5%, and we would have lost untold billions in healthy, inequality-reducing growth.

But if this argument holds--and perhaps others disagree with it--why focus on the NAIRU?

Posted by: Jesse on July 20, 2002 11:42 AM

That's a good point. There was an off-the-record after-dinner Q&A with Greenspan last spring that I was told about where he essentially agreed with you: said that he and the rest of the FOMC had focused on other indicators almost exclusively.

Brad DeLong

Posted by: Brad DeLong on July 20, 2002 03:22 PM

I wonder if there are actual empirical tests of the wage-aspiration theory out there...

Posted by: Nikolai Chuvakhin on July 20, 2002 04:18 PM

There have been many tests of the wage-aspiration theory (none very convincing). A recent American example is Ball and Moffitt, NBER WP 8421.

If you don't use the NAIRU, you either need some other measure of the business cycle (and the alternatives also have their problems) or you foresake counter-cyclical policy.

Posted by: Peter Tulip on July 22, 2002 08:24 AM

the acceptable rate of UNEMPLOYMENT

Posted by: neil on November 4, 2002 05:04 PM
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