NAIRU
Encyclopedia
In monetarist economics, particularly the work of Milton Friedman
, on which also worked Lucas Papademos
and Franco Modigliani
in 1975,
NAIRU is an acronym for Non-Accelerating Inflation
Rate of Unemployment
, and refers to a level of unemployment below which inflation rises.
It is widely used in mainstream economics
.
, who referred to it as "low full employment" attained via the expansion of aggregate demand, in contrast with the "high full employment" which adds incomes policies (wage and price controls) to demand stimulation.
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.
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.
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%.
The NAIRU analysis is especially 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, such as Abba Lerner (1951, 1967) and Hyman Minsky (1965) 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).
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.
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...
, on which also worked Lucas Papademos
Lucas Papademos
Lucas Papademos is a Greek economist who has been appointed as Prime Minister of Greece since 11 November 2011.Previously, he was Governor of the Bank of Greece from 1994 to 2002 and Vice President of the European Central Bank from 2002 to 2010...
and Franco Modigliani
Franco Modigliani
Franco Modigliani was an Italian economist at the MIT Sloan School of Management and MIT Department of Economics, and winner of the Nobel Memorial Prize in Economics in 1985.-Life and career:...
in 1975,
NAIRU is an acronym for Non-Accelerating Inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
Rate of Unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...
, and refers to a level of unemployment below which inflation rises.
It is widely used in mainstream economics
Mainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...
.
Origins
An early form of NAIRU is found in the work of Abba P. LernerAbba P. Lerner
Abba Ptachya Lerner was an American economist.Lerner was born on October 28, 1903 in Bessarabia . He grew up in a Jewish family, which emigrated to Great Britain when Lerner was three years old. Lerner grew up in the London East End. From the age of sixteen he worked as a machinist, a teacher in...
, who referred to it as "low full employment" attained via the expansion of aggregate demand, in contrast with the "high full employment" which adds incomes policies (wage and price controls) to demand stimulation.
The concept arose in the wake of the popularity of the Phillips curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...
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
Industry
Industry refers to the production of an economic good or service within an economy.-Industrial sectors:There are four key industrial economic sectors: the primary sector, largely raw material extraction industries such as mining and farming; the secondary sector, involving refining, construction,...
with more or less mixed economies
Mixed economy
Mixed economy is an economic system in which both the state and private sector direct the economy, reflecting characteristics of both market economies and planned economies. Most mixed economies can be described as market economies with strong regulatory oversight, in addition to having a variety...
. This correlation (previously seen for the U.S. by Irving Fisher
Irving Fisher
Irving Fisher was an American economist, inventor, and health campaigner, and one of the earliest American neoclassical economists, though his later work on debt deflation often regarded as belonging instead to the Post-Keynesian school.Fisher made important contributions to utility theory and...
) 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
Trade-off
A trade-off is a situation that involves losing one quality or aspect of something in return for gaining another quality or aspect...
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
Stagflation
In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high...
.) 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
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...
and Edmund Phelps
Edmund Phelps
Edmund Strother Phelps, Jr. is an American economist and the winner of the 2006 Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel. Early in his career he became renowned for his research at Yale's Cowles Foundation in the first half of the 1960s on the sources of economic growth...
) argued that the Phillips curve could not be a fundamental characteristic of economic general equilibrium
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...
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
Adaptive expectations
In economics, adaptive expectations means that people form their expectations about what will happen in the future based on what has happened in the past...
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.
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 unemploymentFrictional unemployment
Frictional unemployment is the time period between jobs when a worker is searching for, or transitioning from one job to another. It is sometimes called search unemployment and can be voluntary based on the circumstances of the unemployed individual....
associated with individuals changing jobs and possibly classical unemployment arising from real wages being held above the market-clearing level by minimum wage
Minimum wage
A minimum wage is the lowest hourly, daily or monthly remuneration that employers may legally pay to workers. Equivalently, it is the lowest wage at which workers may sell their labour. Although minimum wage laws are in effect in a great many jurisdictions, there are differences of opinion about...
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
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 disinflationDisinflationDisinflation is a decrease in the rate of inflation – a slowdown in the rate of increase of the general price level of goods and services in a nation's gross domestic product over time. It is the opposite of reflation. Disinflation occurs when the increase in the “consumer price level” slows down...
); and
- if U > U* for a few years, inflationary expectations fall, so that the inflation rate tends to slow (there is disinflation
-
- if U = U*, the inflation rate tends to stay the same, unless there is an exogenousExogenousExogenous refers to an action or object coming from outside a system. It is the opposite of endogenous, something generated from within the system....
shock.
- if U = U*, the inflation rate tends to stay the same, unless there is an exogenous
Okun's law
Okun's law
In economics, Okun's law is an empirically observed relationship relating unemployment to losses in a country's production first quantified by Arthur M. Okun. The "gap version" states that for every 1% increase in the unemployment rate, a country's GDP will be at an additional roughly 2% lower...
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
The NAIRU analysis assumes that if inflation increases, workers and employers can create contracts that take into account expectations of higher inflation and agree on a level of wage inflation that matches the expected level of price inflation to maintain constant real wages. Therefore, the analysis requires inflation to accelerate to maintain low unemployment. However, this argument implicitly assumes that workers and employers cannot contract to incorporate accelerating inflation into wage expectations, but there is no clear justification for assuming that expectations or contract structures are limited in this way aside from the fact that such wage arrangements are not commonly observed.The NAIRU analysis is especially 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, such as Abba Lerner (1951, 1967) and Hyman Minsky (1965) have argued that a similar effect can be achieved without the human costs of unemployment via a job guarantee
Job guarantee
A job guarantee is an economic policy proposal aimed at providing a sustainable solution to the dual problems of inflation and unemployment. Its aim is to create full employment and price stability...
, 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).
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 or the credit crunch of the early 21st century.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
Monetarism
Monetarism is a tendency in economic thought that emphasizes the role of governments in controlling the amount of money in circulation. It is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over...
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 PhelpsEdmund PhelpsEdmund Strother Phelps, Jr. is an American economist and the winner of the 2006 Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel. Early in his career he became renowned for his research at Yale's Cowles Foundation in the first half of the 1960s on the sources of economic growth...
- Job guaranteeJob guaranteeA job guarantee is an economic policy proposal aimed at providing a sustainable solution to the dual problems of inflation and unemployment. Its aim is to create full employment and price stability...
- Milton FriedmanMilton FriedmanMilton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...
- Phillips curvePhillips curveIn economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...
- Okun's LawOkun's lawIn economics, Okun's law is an empirically observed relationship relating unemployment to losses in a country's production first quantified by Arthur M. Okun. The "gap version" states that for every 1% increase in the unemployment rate, a country's GDP will be at an additional roughly 2% lower...
- Natural rate of unemploymentNatural rate of unemploymentThe natural rate of unemployment is a concept of economic activity developed in particular by Milton Friedman and Edmund Phelps in the 1960s, both recipients of the Nobel prize in economics...
- Differences between the Natural Rate of Unemployment and the NAIRU