Stirati on the NAIRU

Surprisingly there was no entry on the Non Accelerating Inflation Rate of Unemployment (NAIRU) in the New Palgrave Dictionary of Economics. There is, and remains there, one on Milton Friedman's Natural Rate of Unemployment, written by Michael J. Pries. Both are deeply interconnected concepts. In fact, Antonella Stirati, who I asked to write it, presents the NAIRU as a reformulation of Friedman's natural rate within models that allow for real wage rigidities and involuntary unemployment.

Despite differences in microeconomic foundations, both concepts imply a vertical long-run Phillips curve and share three central propositions. First, the equilibrium unemployment rate is determined independently of aggregate demand. Also, unemployment below it causes accelerating inflation. Finally, actual unemployment is eventually drawn back toward it.

In the standard wage-setting/price-setting model, the NAIRU is the unemployment rate required to reconcile workers' real-wage claims with firms' desired markup. Labor-market institutions (e.g. unemployment benefits, employment protection and union bargaining power) do not directly determine the real wage, which is constrained by productivity and the markup. Instead, they determine how much unemployment is required to discipline workers sufficiently to make wage claims compatible with the markup.

This framework generates a wage-price spiral whenever unemployment departs from the NAIRU. In New Keynesian versions, stronger aggregate demand first reduces involuntary unemployment. Then lower unemployment raises wage claims, which are assumed to pass fully into prices because the real markup is fixed. Monetary policy subsequently raises interest rates, reduces investment and aggregate demand, and restores unemployment to the NAIRU. Stirati emphasizes that this adjustment mechanism depends on two weak assumptions, one that interest rates reliably control private investment and demand, and then that departures from the NAIRU have a sufficiently strong and predictable effect on inflation.

 

The policy consequences are strongly supply-side. Because the NAIRU is attributed to labor-market institutions, reducing unemployment supposedly requires weaker employment protection, lower unemployment benefits, diminished union bargaining power and, sometimes, greater product-market competition. The whole neoliberal policy agenda. Keynesianism is impossible, since aggregate-demand policy can affect unemployment only temporarily, while permanently changing the inflation rate.

 

Her principal criticism concerns estimation. The NAIRU is unobservable, yet it is central to monetary policy, potential-output calculations and European fiscal rules. In practice, estimates are extracted from the trend of actual unemployment or chosen so that the estimated unemployment gap best explains inflation. Consequently, movements in unemployment that do not produce inflation are simply absorbed into a changing estimated NAIRU and relabeled as "structural." The resulting estimates are highly uncertain, frequently revised and closely track actual unemployment, often without corresponding changes in labor-market institutions.

 

The evidence is really against it. Major historical episodes completely contradict the model predictions. For example, persistently high European unemployment did not produce accelerating deflation. Or the low unemployment of the Clinton boom did not produce accelerating inflation, and the sharp post-2008 rise in unemployment did not cause sustained deflation. This suggests that the estimated NAIRU is less an independent structural attractor than a moving average of unemployment shaped by aggregate demand and capital accumulation.

 

The entry’s central argument is that all three defining properties of the NAIRU, its independence from demand, its role as an inflation barrier and its status as an attractor, are theoretically questionable and empirically unsupported. Nevertheless, the concept survives because it remains embedded in macroeconomic models and policy institutions, especially European fiscal policy.

 

The entry requires access to the Palgrave. But many of the same arguments are discussed in her Godley-Tobin Memorial Lecture, freely available here.