NAIRU (non-accelerating inflation rate of unemployment) (1968)

Proposed by American economist Milton Friedman (1912-1992), NAIRU refers to the long-term rate of unemployment at which inflation neither rises nor falls, as upward and downward pressures on wage and price inflation are in equilibrium.

The vertical Phillips curve illustrates this situation.

Source:
M Friedman, ‘The Role of Monetary Policy’, American Economic Review, vol. LVIII (March, 1968), 1-17

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 because some people’s skills were worthless.^[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]

The 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.

The 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<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