May 1, 1998

Federal Reserve Bank of Cleveland

In Search of the NAIRU

by David Altig and Paul Gomme

Few ideas arise more frequently in blessedly been revoked forever. Critics monetary policy discussions than the of this view—economist/columnist Paul NAIRU, an acronym for the awkward Krugman among them—argue that such What do dating and Brad Pitt tell us phrase “nonaccelerating inflation rate a development would be tantamount to about unemployment? of unemployment.” The NAIRU—or repealing the weather. However, these more precisely, its relationship to the critics concede, it is true that sometimes unemployment rate—is presumed to be it rains and sometimes it shines, and a an inflationary bellwether. When the logical interpretation of the recent dis- actual unemployment rate exceeds the crepancy between “theory” and experi- NAIRU, the inflation rate falls; when ence is that good fortune has given us a the actual rate is below the NAIRU, NAIRU that is, in fact, lower than most inflation rises. estimates imply.

For the past several years, the U.S. un- This take on the situation has an air of employment rate has been lower than plausibility because increased productiv- most NAIRU estimates. The 1998 ity, made possible by the maturation of the computer technology revolution, is Economic Report of the President, for 1 example, gave a NAIRU estimate of one obvious source of our good fortune. 5.5 percent for 1997. The actual rate of In essence, favorable technology ad- unemployment, however, began the vances have lowered the NAIRU, and year at 5.3 percent and fell to 4.6 per- the economy has begun operating with a cent by year’s end. Yet, by almost any new speed limit that allows us to enjoy measure, inflation fell throughout 1997 lower unemployment rates without ignit- (see table 1). ing a flare-up in inflation.

This is a perplexing combination of The only problem with this slant on events because, loosely speaking, the events is that it is not obviously correct. NAIRU is thought to represent a natural In this Economic Commentary, we dis- “speed limit” for economic activity. In cuss what the modern theory of labor other words, it measures a nation’s sus- markets has to say about the effect of tainable production capacity. When the productivity shocks on notions like the economy grows at a rate faster than its NAIRU. We conclude that if the NAIRU resources can support over the long run framework is to survive as a viable tool (which presumably occurs when the un- for understanding monetary policy, more employment rate falls below the NAIRU than an appeal to accelerated productiv- for an extended period), price pressures ity growth will be needed to salvage it 2 build and, eventually, burst through to an from its recent failures. acceleration of the inflation rate. ■ Inflation, the NAIRU, and the The NAIRU framework’s apparent fail- “Natural” Rate of Unemployment ure to describe the evolution of inflation What, exactly, is the NAIRU? Strictly over the course of the current expansion speaking, the definition is statistical, not has prompted some brave souls to pro- theoretical: The NAIRU is the unem- claim the dawning of a new economic ployment rate that experience tells us era, one in which “speed limits” have has, on average, been associated with stable inflation when matched by the actual rate of unemployment. ISSN 0428-1276 Why inflation-rate stability would re- find an appropriate partner with whom It is important to recognize that unem- quire that there be no gap between to enter into a long-term relationship. ployment associated with the process actual unemployment rates and the Second, dating is a face-to-face described here is not necessarily a bad NAIRU is not usually made explicit, encounter to evaluate “chemistry,” that thing for the economy. It would clearly which is just to say that the theoretical is, to determine whether the date would be inefficient for a skilled computer pro- foundation of the NAIRU and its role in make a satisfactory partner (what a less grammer to take an entry-level job in determining inflation is often fuzzy. romantically inclined economist might fast food. However, because information Furthermore, using formal economic call assessing the quality of the match). about potential job characteristics is theory to clarify the relationship re- Finally, dating is expensive because it imperfect, the search process takes time quires answering two not-so-easy ques- takes time. to yield the right match, just as Jane tions: What determines the NAIRU? needs time to find the right long-term And how does the unemployment rate Now, let’s consider the behavior of Jane, partner. And just as Jane will remain a and its relationship to the NAIRU affect who is in the dating market. Like all dating single for a while before living the inflation rate? other single people in the economy, she happily ever after, our programmer will combs the personal ads for prospects experience a spell of unemployment We will make no attempt to answer the and, on finding a promising one, sets a before finding the job that maximizes second question, but, for the sake of date to determine whether she chooses to the expected fruits of her labor. argument, will take it as given that infla- enter into a (more or less) permanent tion rate changes result when the unem- relationship. Loosely speaking, then, the natural rate ployment rate deviates from the NAIRU. of unemployment is the level that would Let’s accept provisionally that the infla- Jane, of course, has certain goals and result from the dynamic process of job tion rate falls when the unemployment expectations. As an illustration, suppose creation and destruction, job market rate rises above the NAIRU or, more that she is unwilling to enter into a long- search, and a suitable matching of pertinent to this discussion, when the term relationship with anyone who is employers and employees. NAIRU falls below the existing unem- not at least of, say, Brad Pitt “quality,” ployment rate. where quality is measured by a bundle ■ Dating, Brad Pitt, and the of attributes such as looks, intelligence, “Reservation Wage” So, the question at hand is, What deter- neatness, sense of humor, and so forth. mines the NAIRU? To answer this ques- In the jargon of economics, we might In our earlier example, the length of time tion, we will treat the NAIRU as a syn- refer to Brad Pitt as Jane’s “reservation that Jane remains single depends partly onym for the so-called “natural” rate of partner.” He represents the minimum on luck. If she’s especially fortunate, she unemployment. At this point, you might quality of person whom Jane finds will quickly “draw” a date from the clas- think that we have begged the question acceptable. If her date doesn’t measure sifieds who meets her standards. It is by replacing one ill-defined concept up to Brad Pitt standards, she will refuse possible, however, that she will endure a with another, and to some extent you to see him again, and return to the classi- number of dates that she considers sub- would be correct. For now, though, let’s fieds. However, if her date meets or par before finally hooking up with Brad define the natural rate of unemployment exceeds these standards—and she meets Pitt, his equal, or his superior. as the level associated with the “normal” his as well—Jane enters into a relation- functioning of labor markets. ship and forsakes the dating scene. But Jane’s dating fortunes are not entirely beyond her control. She knows But what’s normal? To that question we The critical aspect of this example is the likelihood of finding a Brad Pitt in turn next. that, although Jane’s goal is to exit the the dating pool, and thus knows the dating market, she will only do so if she probability of having a date that does ■ The Dating Game: finds a suitable match (someone at least not live up to her expectations. Although A Useful Metaphor as good as Brad Pitt.) Thus, there will the process inevitably contains some To understand labor markets better, we very likely be some time during which element of chance, Jane can certainly will take a slight detour and contemplate Jane chooses to be single. increase the probability of beginning a the age-old ritual of dating, which, at long-term relationship on any given date first blush, may seem worlds away from ■ Search and Equilibrium if she simply lowers her standards. In the unemployment question. But, as we Unemployment other words, the time that she can expect shall see, the dating “market” has impor- With a little imagination, it is easy to see to remain single will be reduced if the tant parallels to the labor market, paral- the similarity between labor markets and “reservation partner” she chooses—the lels that will help us define precisely the dating market just described. In par- minimally acceptable long-term mate— what we mean by a normal (or natural) ticular, at any given time there will be is of lesser quality than Brad Pitt. rate of unemployment. unemployed persons who, like Jane, are forgoing possible long-term relation- So, how does Jane determine that Brad To start, let’s consider a highly stylized ships in order to seek more desirable Pitt is her “reservation partner?” The cal- version of dating—an economic model, matches. An unemployed computer pro- culation has two key components: First, if you will. As with all economic mod- grammer, for example, might receive job she knows the probability that any given els, we make certain abstractions to help offers from plenty of fast-food restau- date will exceed some particular quality isolate the essential characteristics of the rants, but would refuse them because level. Second, she knows the cost of not behavior that interests us. The essentials they do not meet a minimum standard, accepting a long-term relationship and of our particular dating market are these: which we will summarize by the wage continuing to look. Thus, on any particu- First, the sole objective of dating is to that is offered. lar date, she knows the likely benefit of TABLE 1 VARIOUS MEASURES OF INFLATION This equivalence occurs because the cost of continued searching is the opportunity CPI Core CPI cost of forgone wage offers. As a conse- December Year December Year quence, the minimum acceptable wage to to to to offer rises by 10 percent, leaving the December Year December Year expected spell of unemployment un- changed by the productivity improve- 1996 3.3 3.0 2.6 2.7 ment. Extending this logic to the entire 1997 1.7 2.3 2.2 2.4 labor force means, of course, that the natural rate of unemployment (NAIRU PPI: Total Finished Goods PPI: Finished Consumer Goods in the monetary policy context) is invari- December Year December Year ant—that is, unresponsive—to produc- to to to to tivity increases. December Year December Year ■ Can Productivity Growth 1996 2.8 2.7 3.4 3.6 Ever Change the NAIRU? 1997 –1.2 0.4 –1.0 0.7 Like all economic parables, this one’s SOURCE: Economic Report of the President, February 1998. Washington, D.C.: U.S. Govern- moral depends on the details. Is it pos- ment Printing Office, 1998. sible, in any well-constructed world, for productivity changes to alter the NAIRU? Yes, almost certainly, but getting to this conclusion requires a sloughing the fellow off and looking tions that unemployed workers use fancier story than the usual straight- elsewhere—which is determined by the when searching for jobs. forward productivity tale. probability of finding a higher-quality man in the future—as well as the costs Will this be the case? Let’s return once One possibility is that workers fail to of continued search. The reservation more to our dating metaphor. Suppose perceive how far their productivity has partner, then, is the one for whom the that the quality of all men magically risen, and hence misjudge the wage that costs of continued dating just equal the increases by, say, 10 percent. Would the they can rationally expect to receive. If a expected return of continued dating. In number of men Jane would accept as productivity advance, for example, 3 Jane’s case, that person is Brad Pitt. partners increase, thus reducing the time causes all potential wage offers to rise 10 she can expect to remain single? percent, the logic of our earlier argument The same logic applies to our unem- suggests that workers’ reservation wages ployed computer programmer. Just as To address this question, it will help if we should also increase 10 percent. If, how- Jane calculates the benefits and costs of make our example a bit more specific. ever, job-seekers do not recognize the dating, the programmer calculates the Suppose that after this wonderful 10 per- full extent of their good fortune, they probability of finding a better job than cent improvement, Dexter Pitt (Brad’s may accept jobs at wages below what the one currently offered, and balances less desirable distant cousin) is of the they would accept if they were fully that against the cost of a longer spell of same quality as Brad was before the aware of their improved circumstances. unemployment. The wage at which the transformation. Will Jane now be willing In other words, some people will take benefits of continued job search just to enter into a relationship with Dexter? jobs that they should really reject equal the costs of further search is called because, unbeknownst to them, the true In the absence of other changes, the the reservation wage, which represents benefit of finding a better job exceeds answer is no. It’s true that the benefit of the minimum wage offer for which our their cost of remaining unemployed and settling for Dexter has risen. But so has programmer will choose employment continuing the search. over unemployment. the cost, because Jane loses even more than before by not holding out for Brad, Thus, temporary confusion about wage ■ Do Productivity Increases whose quality has risen as well. In fact, prospects causes the NAIRU (or natural Lower the NAIRU? it turns out that revisions in costs and rate) to fall. The operative word here is Now we are in a better position to eval- benefits offset one another: Jane’s reser- temporary. Once the effects of produc- uate the claim that significant productiv- vation partner will still be Brad Pitt, and tivity developments become known, the ity gains have lowered the natural rate, she will expect to spend exactly the NAIRU will revert to its initial level, as thus driving the NAIRU down below same amount of time dating (remaining in the story we developed in the preced- the actual unemployment rate and yield- single) as she did before the pool of men ing sections. ing the happy environment in which miraculously improved. both the unemployment and inflation rates fall. As our earlier discussion And so it will be with an unemployed makes clear, labor market theory says person’s reservation wage. To the extent that this story can only be true if such that a productivity increase raises all productivity developments fundamen- potential wage offers by the same tally change the cost-benefit calcula- amount, say 10 percent, the benefits and costs of search also rise by 10 percent. Another possibility is that recent produc- ■ Footnotes tivity changes are not of the sort that 1 On the face of it, this view is not strongly raises all wages by 10 percent, but rather supported by actual productivity numbers, David Altig is a vice president and economist of the sort whose effects vary substan- prompting some of its adherents to claim that at the Federal Reserve Bank of Cleveland, tially across the range of jobs. Such a reality is being obscured by technical mea- surement problems. For a critical assessment and Paul Gomme is an economist there. scenario would very likely change the of this argument, see John B. Carlson and The views stated herein are those of the NAIRU’s level. However, both theory Mark Schweitzer, “Productivity Measures authors and not necessarily those of the and experience are generally silent on and the ‘New Economy,’” Federal Reserve Federal Reserve Bank of Cleveland or of the the direction of such a change. Bank of Cleveland, Economic Commentary, forthcoming. Board of Governors of the Federal Reserve The moral of this story is that, although System. appeals to productivity growth could 2. For a fuller development of the ideas in this Economic Commentary, see Paul conceivably salvage the recent poor per- Economic Commentary is available elec- Gomme, “What Labor Market Theory Tells formance of NAIRU-based predictions, Us about the ‘New Economy,’ ” Federal tronically through the Cleveland Fed’s site on salvation from this source seems to Reserve Bank of Cleveland, Economic the World Wide Web: http://www.clev.frb.org. require extremely persistent confusion Review, forthcoming. We also offer a free online subscription serv- on the part of workers or an appeal to ice to notify readers of additions to our Web predictions that are difficult to support 3. In general, Jane’s calculation will involve site. To subscribe, please send an e-mail mes- by logic or facts. Maybe it can be res- the probability that her desire to enter into a long-term relationship will be reciprocated sage to [email protected]. cued, but maybe—just maybe—it’s by her date. However, we have implicitly as- simply time to replace the NAIRU with sumed that these desires will always be reci- a more sophisticated framework for con- procated, which probably means that Jane is necting the labor market to policy. herself a pretty good catch.

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