Non-Accelerating Inflation Rate of Unemployment

Posted on by user

Non-Accelerating Inflation Rate of Unemployment (NAIRU)

The non-accelerating inflation rate of unemployment (NAIRU) is the unemployment rate at which inflation is stable — not rising or falling. It represents an equilibrium between labor-market slack and inflationary pressure: when actual unemployment equals NAIRU, inflation tends to remain constant; when unemployment falls below NAIRU, inflation tends to accelerate; when it rises above NAIRU, inflation tends to decelerate.

Key points

  • NAIRU is an empirical concept, not a precise formula; it is estimated with statistical models.
  • Historically, U.S. estimates placed NAIRU around 5–6%; more recent estimates often range 4–5%.
  • The Federal Reserve uses such estimates when balancing its dual mandate of price stability (often a 2% inflation target) and maximum employment.
  • NAIRU captures the relationship between unemployment and inflation but does not explain all drivers of inflation.

How NAIRU works

  • Labor-market tightness affects wages and prices. Lower unemployment increases workers’ bargaining power, pushing wages and then prices higher; higher unemployment reduces wage pressure and slows inflation.
  • Policymakers use NAIRU estimates to judge whether economic slack will push inflation away from their target. If unemployment is below NAIRU and inflation looks set to rise above target, central banks may tighten policy to cool demand.
  • There is no single, fixed NAIRU — it can shift over time with changes in labor-market structure, demographics, productivity, and institutions.

Simple example

If the economy has 5% unemployment and 2% inflation for an extended period, economists might infer that NAIRU ≈ 5% for that environment. If unemployment drops to 4% and stays there, inflation expectations could rise and actual inflation may accelerate above 2%.

Origins and theory

  • The idea traces to the Phillips curve (A.W. Phillips, 1958), which documented an inverse relationship between unemployment and wage inflation.
  • In the 1970s, episodes of high inflation and high unemployment (stagflation) challenged the simple Phillips-curve view. Milton Friedman argued that inflation expectations matter and that pushing unemployment below a certain level would only accelerate inflation.
  • The NAIRU concept (introduced as NIRU in 1975 by Franco Modigliani and Lucas Papademos) refines this by implying a noninflationary unemployment “threshold” consistent with longer-run equilibrium.

NAIRU vs. natural rate of unemployment

  • Natural unemployment (or the natural rate) reflects structural, frictional, and voluntary reasons workers may be between jobs — factors like skill mismatches, technological change, and job search.
  • NAIRU specifically links unemployment to inflation behavior. While related, the two concepts emphasize different mechanisms: natural unemployment is a structural notion; NAIRU is a policy-relevant inflation benchmark.

Limitations and criticisms

  • Estimation uncertainty: NAIRU is not directly observable and estimates vary widely depending on models and assumptions.
  • Other inflation drivers: Supply shocks, commodity prices, fiscal policy, and global factors can alter inflation independently of domestic unemployment.
  • Time variation: Structural changes in the labor market (technology, labor-force participation, globalization) can shift NAIRU, making past estimates unreliable for current policy.
  • Social costs: Using NAIRU as a policy guide can imply tolerating higher unemployment to curb inflation, which has social and economic costs.

Policy implications

  • Central banks consider NAIRU when weighing whether the economy is overheating or has slack. If unemployment is persistently below estimated NAIRU, they may tighten policy to prevent accelerating inflation.
  • Because NAIRU estimates are uncertain and shifting, policymakers typically combine them with a wide range of indicators (wage growth, inflation expectations, labor participation, productivity) rather than relying on NAIRU alone.

Conclusion

NAIRU is a useful conceptual tool for linking labor-market conditions with inflation dynamics: it frames the unemployment level at which inflation neither accelerates nor decelerates. However, its practical application is limited by estimation uncertainty, changing economic structure, and the many other factors that influence inflation. Policymakers use NAIRU estimates cautiously, alongside broader economic evidence.