# NAIRU

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Non-accelerating inflation rate of unemployment (NAIRU) [1] is a theoretical level of unemployment below which inflation would be expected to rise. [2] It was first introduced as NIRU (non-inflationary rate of unemployment) by Franco Modigliani and Lucas Papademos in 1975, as an improvement over the "natural rate of unemployment" concept, [3] [4] [5] which was proposed earlier by Milton Friedman. [6]

## Contents

In the United States, estimates of NAIRU typically range between 5 and 6%. [2] Monetary policy conducted under the assumption of a NAIRU typically involves allowing just enough unemployment in the economy to prevent inflation rising above a given target figure. Prices are allowed to increase gradually and some unemployment is tolerated.

## 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" 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. Friedrich von Hayek argued that governments attempting to achieve full employment would accelerate inflation where unemployment results from a misalignment between the distribution of labour and the distribution of demand. [7]

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, was that 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. [8]

### Natural rate hypothesis

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.

### NAIRU

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, any particular preferred policy remedy or a prediction that the rate would be stable over time. Franco Modigliani and Lucas Papademos defined the noninflationary rate of employment (NIRU) as the rate of employment above which inflation could be expected to decline, and attempted to estimate it from empirical data [9] James Tobin suggested the reason for them choosing a different term was to avoid the "normative implications" of the concept of a 'natural' rate. [10] He also argued that the idea of a 'natural' rate of unemployment should be viewed as closely linked to Friedman's description of it as the unemployment rate emerging in general equilibrium, when all other parts of the economy clear, whereas the notion of a NAIRU was compatible with an economy in which other markets need not be in equilibrium. [10] In practice the terms can be viewed as approximately synonymous. [11]

## Properties

If ${\displaystyle U^{*}}$ is the NAIRU and ${\displaystyle U}$ is the actual unemployment rate, the theory says that:

if ${\displaystyle U for a few years, inflationary expectations rise, so that the inflation rate tends to increase;
if ${\displaystyle U>U^{*}}$ for a few years, inflationary expectations fall, so that the inflation rate tends to slow (there is disinflation); and
if ${\displaystyle U=U^{*}}$, the inflation rate tends to stay the same, unless there is an exogenous shock.

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 level of the NAIRU itself is assumed to fluctuate over time as the relationship between unemployment level and pressure on wage levels is affected by productivity, demographics and public policies [11] In Australia, for example, the NAIRU is estimated to have fallen from around 6% in the late 1990s to closer to 4% twenty years later in 2018. [12]

## 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). 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.

## United States boom years of late 1990s and early 2000s

In the U.S. boom years of 1998, 1999, and 2000, unemployment dipped below NAIRU estimates without causing significant increases of inflation. There are at least three potential explanations of this: (1) Fed Chair Alan Greenspan had correctly judged that the Internet revolution had structurally lowered NAIRU, or (2) NAIRU is largely mistaken as a concept, or (3) NAIRU correctly applies only to certain historical periods, for example, the 1970s when a higher percentage of workers belonged to unions and some contracts had wage increases tied in advance to the inflation rate, but perhaps neither as accurately nor as correctly to other time periods. [2]

Vox reporter Matthew Yglesias wrote of the late 1990s, "Everyone — from college students to stay-at-home moms to sixty-somethings to low-level drug dealers — becomes somewhat more inclined to seek formal employment. That lets veteran workers get higher pay, even as companies are able to maintain some lower-pay work thanks to the growing labor force. This is essentially what we saw happen during the boom years of 1998 and 1999. Wages did rise, but the labor force also grew quite rapidly, and inflation remained under control." [2]

The unemployment rate declined to 4% for Dec. 1999, hit a low of 3.8% for April 2000, and held at 3.9% for four months from Sept. to Dec. 2000. [13] This is the U-3 rate, which is what's most commonly reported in the news. It does not include either persons termed discouraged workers nor those with part-time employment actively seeking full-time. [14]

## Criticism

Since NAIRU can vary over time, any estimates of the NAIRU at any point in time have a relatively wide margin for error, which limits its practical value as a policymaking tool. [11] As the NAIRU is inferred from levels of inflation and unemployment and the relationship between those variables is acknowledged to vary over time, some economists have questioned whether there is any real empirical evidence for it at all. [15]

The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. [16] This could happen, for example, if unemployed workers lose skills and thus companies prefer to bid up of the wages of existing workers rather than hire unemployed workers.

Some economists who favour the provision of a state job guarantee, such as Bill Mitchell, have argued that a certain level of state-provided "buffer" employment for people unable to find private sector jobs, which they refer to as a NAIBER (non-accelerating inflation buffer employment ratio), [17] is also consistent with price stability.

## Naming

According to Case, Fair and Oster, the NAIRU is misnamed because it is not actually a "non-accelerating inflation rate of unemployment". Rather, they claim it is the price level that is accelerating (or decelerating), not the inflation rate. The inflation rate is just changing, not accelerating. [18]

## Related Research Articles

Macroeconomics is a branch of economics which deals with the performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, and government spending to regulate an economy's growth and stability. This includes regional, national, and global economies. According to a 2018 assessment by economists Emi Nakamura and Jón Steinsson, economic "evidence regarding the consequences of different macroeconomic policies is still highly imperfect and open to serious criticism."

In economics, stagflation or recession-inflation is a situation in which the inflation rate is high or increasing, the economic growth rate slows, and unemployment remains steadily high. It presents a dilemma for economic policy, since actions intended to lower inflation may exacerbate unemployment.

Unemployment, according to the OECD, is people above a specified age not being in paid employment or self-employment but currently available for work during the reference period.

In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money. The opposite of inflation is deflation, a sustained decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualized percentage change in a general price index. As prices do not all increase at the same rate, the consumer price index (CPI) is often used for this purpose. The employment cost index is also used for wages in the United States.

Full employment is a situation in which there is no cyclical or deficient-demand unemployment. Full employment does not entail the disappearance of all unemployment, as other kinds of unemployment, namely structural and frictional, may remain. For instance, workers who are "between jobs" for short periods of time as they search for better employment are not counted against full employment, as such unemployment is frictional rather than cyclical. An economy with full employment might also have unemployment or underemployment where part-time workers cannot find jobs appropriate to their skill level, as such unemployment is considered structural rather than cyclical. Full employment marks the point past which expansionary fiscal and/or monetary policy cannot reduce unemployment any further without causing inflation.

Franco Modigliani was an Italian-American economist and the recipient of the 1985 Nobel Memorial Prize in Economics. He was a professor at University of Illinois at Urbana–Champaign, Carnegie Mellon University, and MIT Sloan School of Management.

New Keynesian economics is a school of macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroeconomics.

This aims to be a complete article list of economics topics:

The Phillips curve is an economic model, named after William Phillips hypothesizing a correlation between reduction in unemployment and increased rates of wage rises within an economy. While Phillips himself did not state a linked relationship between employment and inflation, this was a trivial deduction from his statistical findings. Paul Samuelson and Robert Solow made the connection explicit and subsequently Milton Friedman and Edmund Phelps put the theoretical structure in place.

The natural rate of unemployment is the name that was given to a key concept in the study of economic activity. Milton Friedman and Edmund Phelps, tackling this 'human' problem in the 1960s, both received the Nobel Memorial Prize in Economic Sciences for their work, and the development of the concept is cited as a main motivation behind the prize. A simplistic summary of the concept is: 'The natural rate of unemployment, when an economy is in a steady state of "full employment", is the proportion of the workforce who are unemployed'. Put another way, this concept clarifies that the economic term "full employment" does not mean "zero unemployment". It represents the hypothetical unemployment rate consistent with aggregate production being at the "long-run" level. This level is consistent with aggregate production in the absence of various temporary frictions such as incomplete price adjustment in labor and goods markets. The natural rate of unemployment therefore corresponds to the unemployment rate prevailing under a classical view of determination of activity.

Neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages, and exchange rates, with no effect on real variables, like employment, real GDP, and real consumption. Neutrality of money is an important idea in classical economics and is related to the classical dichotomy. It implies that the central bank does not affect the real economy by creating money. Instead, any increase in the supply of money would be offset by a proportional rise in prices and wages. This assumption underlies some mainstream macroeconomic models. Others like monetarism view money as being neutral only in the long run.

Edmund Strother Phelps is an American economist and the recipient of the 2006 Nobel Memorial Prize in Economic Sciences.

The AD–AS or aggregate demand–aggregate supply model is a macroeconomic model that explains price level and output through the relationship of aggregate demand (AD) and aggregate supply (AS).

The Brookings Papers on Economic Activity (BPEA) is a journal of macroeconomics published twice a year by the Brookings Institution Press.[1] Each issue of the journal comprises the proceedings of a conference held biannually by the Economic Studies program at the Brookings Institution in Washington D.C. The conference and journal both “emphasize innovative analysis that has an empirical orientation, take real-world institutions seriously, and is relevant to economic policy.”[2]

Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.

Inflationism is a heterodox economic, fiscal, or monetary policy, that predicts that a substantial level of inflation is harmless, desirable or even advantageous. Similarly, inflationist economists advocate for an inflationist policy.

In economics, hysteresis consists of effects that persist after the initial causes giving rise to the effects are removed. Two of the main areas in economics where hysteresis effects are invoked to explain economic phenomena are unemployment and international trade.

The Lucas aggregate supply function or Lucas "surprise" supply function, based on the Lucas imperfect information model, is a representation of aggregate supply based on the work of new classical economist Robert Lucas. The model states that economic output is a function of money or price "surprise". The model accounts for the empirically based trade off between output and prices represented by the Phillips curve, but the function breaks from the Phillips curve since only unanticipated price level changes lead to changes in output. The model accounts for empirically observed short-run correlations between output and prices, but maintains the neutrality of money in the long-run. The policy ineffectiveness proposition extends the model by arguing that, since people with rational expectations cannot be systematically surprised by monetary policy, monetary policy cannot be used to systematically influence the economy.

Full Employment Abandoned: Shifting Sands and Policy Failures is a book on macroeconomic issues written by economists Bill Mitchell and Joan Muysken and first published in 2008.

In economics, non-accelerating inflation buffer employment ratio (NAIBER) refers to a systemic proposal for an in-built inflation control mechanism devised by economists Bill Mitchell and Warren Mosler, and advocated by Modern Money Theory as replacement for NAIRU. The concept of NAIBER is related to the idea of a job guarantee aimed to create full employment and price stability, by having the state promise to hire unemployed workers as an employer of last resort (ELR).

## References

1. Coe, David T, Nominal Wages. The NAIRU and Wage Flexibility. (PDF), Organisation for Economic Co-operation and Development
2. The NAIRU, explained: why economists don't want unemployment to drop too low, Vox, Matthew Yglesias, Nov 14, 2014. " . . it's broadly agreed that the NAIRU can change over time. . "
3. Modigliani, Franco; Papademos, Lucas (1975). "Targets for Monetary Policy in the Coming Year" (PDF). Brookings Papers on Economic Activity . The Brookings Institution. 1975 (1): 141–165. doi:10.2307/2534063. JSTOR   2534063.
4. Robert M. Solow, Modigliani and Monetarism Archived 2014-12-28 at the Wayback Machine , p. 6.
5. Snowdon, Brian; Vane, Howard R. (2005). Modern Macroeconomics: Its Origins, Development and Current State. Cheltenham: E. Elgar. p. 187. ISBN   1-84376-394-X.
6. Friedman, Milton (1968). "The Role of Monetary Policy". American Economic Review . 58 (1): 1–17. JSTOR   1831652.
7. FA Hayek, ‘Full Employment, Planning and Inflation’ (1950) 4(6) Institute of Public Affairs Review 174. E McGaughey, 'Will Robots Automate Your Job Away? Full Employment, Basic Income, and Economic Democracy' (2018) SSRN, part 2(1), 5
8. Hoover, Kevin D, "Phillips Curve", The Concise Encyclopedia of Economics, The Library of Economics and Liberty, retrieved 16 July 2007
9. Modigliani, Franco; Papademos, Lucas (1975). "Targets for Monetary Policy in the Coming Year" (PDF). Brookings Papers on Economic Activity . The Brookings Institution. 1975 (1): 141–165. doi:10.2307/2534063. JSTOR   2534063.
10. Tobin, James (April 1997). "SUPPLY CONSTRAINTS ON EMPLOYMENT AND OUTPUT: NAIRU VERSUS NATURAL RATE" (PDF). Cowles Foundation Discussion Paper. Retrieved 8 June 2018.
11. Ball, Laurence; Mankiw, N. Gregory (2002). "The NAIRU in Theory and Practice" (PDF). Journal of Economic Perspectives. 16 (4): 115–136. doi:10.1257/089533002320951000 . Retrieved 8 June 2018.
12. See the discussion about problems of estimating the NAIRU in Australia in Luci Ellis, 'Watching the invisibles: The 2019 Freebairn Lecture in Public Policy', Reserve Bank of Australia, 12 June 2019.
13. Unemployment rate, Federal Reserve Economic Data ("FRED"), St. Louis Fed Branch, U-3 unemployment is defined as unemployed persons as percent of labor pool (labor pool is persons employed or actively seeking), data from Jan. 1948 to present.
14. Alternative measures of labor underutilization, Federal Reserve Economic Data ("FRED"), St. Louis Federal Reserve, graphs are available showing Jan. 1994 to present.
15. E McGaughey, 'Will Robots Automate Your Job Away? Full Employment, Basic Income, and Economic Democracy' (2018) SSRN, part 2(1). SP Hargreaves Heap, ‘Choosing the Wrong ‘Natural’ Rate: Accelerating Inflation or Decelerating Employment and Growth?’ (1980) 90(359) Economic Journal 611. K Clark and L Summers, ‘Labour Force Participation: Timing and Persistence’ (1982) 49(5) Review of Economic Studies 825.
16. Ball, Laurence (2009), Hysteresis in Unemployment: Old and New Evidence (PDF)
17. William Mitchell, J. Muysken (2008), Full employment abandoned: shifting sands and policy failures, Edward Elgar Publishing, ISBN   978-1-85898-507-7
18. Case, K.E.; Fair, R.C.; Oster, S.M. (2016). Principles of Macroeconomics. Pearson. ISBN   9780133023671.