nairu

In monetarist economics, particularly the work of Milton Friedman, NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment,^[1] and refers to a level of unemployment below which inflation rises. It is widely used in mainstream economics, but is rejected by other economists such as James Tobin – and, in earlier forms, by John Maynard Keynes – who argue that literal full employment – a rate of unemployment close to 0% – is natural and attainable.^{[citation needed]}

Related concepts

NAIRU is often conflated with the notions of a natural rate of unemployment and full employment.

This "full employment" unemployment rate is sometimes termed the "inflation-threshold unemployment rate": Actual unemployment cannot fall below the NAIRU, and the inflation rate is likely to rise quickly (accelerate) in times of strong labor demands during periods of growth.^[2] It is sometimes referred to as the "natural rate of unemployment" as well, although this term describes an estimated unemployment rate derived from the market's actual performance while the NAIRU is calculated from the Philips Curve.^[3] The point at which the Philips curve, which relates unemployment to inflation, intersects the horizontal axis indicates the NAIRU.^[4] In terms of output, the NAIRU corresponds to potential output, the highest level of real gross domestic product that can be sustained at any one time. This is also called the "natural gross domestic product."

It is a concept in economic theory significant in the interplay of macroeconomics and microeconomics.

Origins

An early form of NAIRU is found in the work of Abba P. Lerner (Lerner 1951, Chapter 14), who referred to it as "low full employment", to contrast with the "high full employment" achievable under his theory of functional finance.

The concept arose in the wake of the popularity of the Phillips curve which summarized the observed negative correlation between the rate of unemployment and the rate of inflation (measured as annual nominal wage growth of employees) for a number of industrialised countries with more or less mixed economies. This correlation (previously seen for the U.S. by Irving Fisher) persuaded some analysts that it was impossible for governments simultaneously to target both arbitrarily low unemployment and price stability, and that, therefore, it was government's role to seek a point on the trade-off between unemployment and inflation which matched a domestic social consensus.

During the 1970s in the United States and several other industrialized countries, Phillips curve analysis became less popular, because inflation rose at the same time that unemployment rose. (See stagflation.) Worse as far as many economists were concerned, the Phillips curve had little or no theoretical basis. Critics of this analysis (such as Milton Friedman and Edmund Phelps) argued that the Phillips curve could not be a fundamental characteristic of economic general equilibrium because it showed a correlation between a real economic variable (the unemployment rate) and a nominal economic variable (the inflation rate). Their counter-analysis was that government macroeconomic policy (primarily monetary policy) was being driven by a low unemployment target and that this caused expectations of inflation to change, so that steadily accelerating inflation rather than reduced unemployment was the result. The resulting prescription was that government economic policy (or at least monetary policy) should not be influenced by any level of unemployment below a critical level - the "natural rate" or NAIRU.^[5]

The natural rate hypothesis and the NAIRU

The idea behind the natural rate hypothesis put forward by Friedman was that any given labor market structure must involve a certain amount of unemployment, including frictional unemployment associated with individuals changing jobs and possibly classical unemployment arising from real wages being held above the market-clearing level by minimum wage laws, trade unions or other labour market institutions. Unexpected inflation might allow unemployment to fall below the natural rate by temporarily depressing real wages, but this effect would dissipate once expectations about inflation were corrected. Only with continuously accelerating inflation could rates of unemployment below the natural rate be maintained.

The analysis supporting the natural rate hypothesis was controversial, and empirical evidence suggested that the natural rate varied over time in ways that could not easily be explained by changes in labor market structures. As a result the "natural rate" terminology was largely supplanted by that of the NAIRU, which referred to a rate of unemployment below which inflation would accelerate, but did not imply a commitment to any particular theoretical explanation, or a prediction that the rate would be stable over time.

Properties of the NAIRU

If U* is the NAIRU and U is the actual unemployment rate, the theory says that:

if U < U* for a few years, inflationary expectations rise, so that the inflation rate tends to accelerate;

if U > U* for a few years, inflationary expectations fall, so that the inflation rate tends to slow (there is disinflation); and

if U = U*, the inflation rate tends to stay the same, unless there is an exogenous shock.

Natural Unemployment Rate

Okun's law can be stated as saying that for every one percentage point by which the actual unemployment rate exceeds the so-called "natural" rate of unemployment, real gross domestic product is reduced by 2% to 3%.

Criticism of the NAIRU

The NAIRU analysis is problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed.

Others^{[weasel words]} have argued that a similar effect can be achieved without the human costs of unemployment via a job guarantee, where rather than being unemployed, those who cannot find work in the private sector should be employed by the government. This theory replaces the NAIRU with the NAIBER (non-accelerating-inflation-buffer employment ratio).^{[citation needed]}

Relationship to Other Economic Theories

Most economists do not see the NAIRU theory as explaining all inflation. Instead, it is possible to move along a short run Phillips Curve (even though the NAIRU theory says that this curve shifts in the longer run) so that unemployment can rise or fall due to changes in inflation. Exogenous supply-shock inflation is also possible, as with the "energy crises" of the 1970s.

The NAIRU theory was mainly intended as an argument against active Keynesian demand management and in favor of free markets (at least on the macroeconomic level). There is, for instance, no theoretical basis for predicting the NAIRU. Monetarists instead support the generalized assertion that the correct approach to unemployment is through microeconomic measures (to lower the NAIRU whatever its exact level), rather than macroeconomic activity based on an estimate of the NAIRU in relation to the actual level of unemployment. Monetary policy, they maintain, should aim instead at stabilizing the inflation rate.

See also

• Edmund Phelps
• Job guarantee
• Milton Friedman
• Phillips curve
• Okun's Law
• Natural rate of unemployment
• Differences between the Natural Rate of Unemployment and the NAIRU

References

Further reading

• Turner, Dave; et al (2001). "Estimating the Structural rate of Unemployment for the OECD Countries". OECD Economic Studies (Organisation for Economic Co-operation and Development) (No. 33): 171-216. http://www.oecd.org/dataoecd/27/46/18464874.pdf. Retrieved 16 July 2007. 

External links

• NAIRU