The NAIRU in Theory and Practice
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Journalof Economic Perspectives—Volume 16,Number 4—Fall 2002—Pages 115– 136 TheNAIRU inTheory and Practice LaurenceBall and N.Gregory Mankiw AIRU stands forthe nonaccelerating in ation rateof unemployment.It isbeyond disputethat this acronym isan uglyaddition tothe English N language. Thereare, however, two issues that failto command consensus among economists, which weaddress inthis essay. The rstissue is whetherthe concept ofthe NAIRU isa usefulpiece of business cycletheory. We believeit is, and webegin this paperby attempting to explain why. In ourview, the NAIRU isapproximately a synonym forthe natural rateof unemployment.This concept followsnaturally from any theorythat says that changes inmonetarypolicy, and aggregatedemand moregenerally, push ination and unemploymentin opposite directions in the short run. Once this short-run tradeoffis admitted, there must besome level of unemployment consistent with stablein ation. Thesecond issueis why the NAIRU changes overtime and, inparticular,why itfellin thesecond half ofthe1990s. This questionis more dif cult, and theanswer isopen todebate. Most likely,various factors areat work,including demographics and governmentpolicies. Yet one hypothesis stands out as particularlypromising: uctuations inthe NAIRU appear relatedto uctuations inproductivity. In the 1970s,the NAIRU rosewhen productivitygrowth slowed. In the1990s, the NAIRU fellwhen productivitygrowth sped up. Developingand testingmodels that explain thelinks among ination, unemploymentand productivityremains a challengefor students ofbusiness cycletheory. y Laurence Ball isProfessorof Economics,Johns Hopkins University, Baltimore, Maryland. N.Gregory Mankiwis Professor of Economics, Harvard University, Cambridge, Massachusetts. 116Journal of Economic Perspectives The Role of NAIRU The word “NAIRU” enteredthe language of macroeconomicsin the1970s, a periodof rapid and risingin ation. Yet,in a deepersense, theconcept has been thereall along. ABuildingBlock of Macroeconomic Theory Alongtradition in economicsemphasizes that thesupply ofmoney in uences both in ation and unemployment.In his classic 1752essay “Of Money,” David Humewrote about theeffects of monetary injections, such as golddiscoveries: “It iseasyto tracethe money in itsprogress through thewhole commonwealth; where we shall nd that itmust rstquicken the diligence of every individual, before it increasesthe price of labour. ” This insighthas motivatedmuch ofmodern macro- economictheory. Two prominent examples are Milton Friedman ’s(1968)presi- dentialaddress tothe American Economic Association and RobertLucas ’s (1996) Nobelprize lecture. Lucas quotesexactly these words from Hume. Attimes,some economists have questionedHume ’sinsight. Thereal business cycletheorists of the 1980s, for example, suggested that business cycleswere technologicallydriven and that moneyhad no rolein explaining production and employment uctuations (Prescott,1986; Long and Plosser,1983). But this viewis aminorityposition, both historicallyand today. Thereis wideagreement about the fundamental insightthat monetary uctuations push in ation and unemployment inopposite directions. That is, societyfaces atradeoff,at leastin the short run, between in ation and unemployment. Accordingto conventional macroeconomic theory, the in ation-unemployment tradeoffis centralto understanding not onlythe effects of monetary policy but also otherpolicies and eventsthat in uencethe aggregate demand forgoods and services.But most of these other events and policiescan potentiallyhave effects through otherchannels as well.For example, tax policy in uences both aggregate demand through disposableincome and aggregatesupply through workincentives. Bycontrast, beliefthat monetarypolicy has employmenteffects is inextricably tied tobelief in the in ation-unemploymenttradeoff. Twocenturies have passed sinceHume penned thewise words quoted above, but theeconomics profession has yetto reacha consensus about whythis tradeoff arises.In classical theory,money is neutral. It isonlythe numeraire in which prices arequoted. Changes inits quantity should affectthe overall price level, but not relativeprices, production oremployment. The key question facing business cycle theoristsis why this classical theoremof monetary neutrality fails to hold inthe world. Many answers have beenproposed. Short-run nonneutralityhas beenblamed on imperfectionsof information (Friedman, 1968; Lucas, 1973;Mankiw and Reis, 2001);long-term labor contracts (Fischer,1977; Gray, 1976; Taylor, 1980); the costs ofprice adjustment (Rotemberg,1982; Mankiw, 1985;Blanchard and Kiyotaki, Laurence Ball andN. Gregory Mankiw117 1987;Ball and Romer,1990); or departures from full rationality (Akerlof and Yellen,1985). Each ofthese approaches raisesits own setof dif culttheoretical and empiricalquestions, which arebeyond thescope ofthis essay. Thereis, however,a common theme:because ofsome market imperfection absent fromthe classical model,changes inthe value of the unit ofaccount matter.Monetary neutrality breaksdown, and at leastin theshort run, monetarychanges have oppositeeffects on in ation and unemployment. Without much loss ofgenerality, we can writethe short-run tradeoffbetween in ation and unemployment U as follows: 5 k 2 aU, where k and a . 0areparameters. This equationdoes not reallysay much, other than that and U arenegatively related. One fact about this relationshipis clear: itcannot beconstant overtime. If itwere,the data onin ation and unemployment wouldtrace a nice,stable, downward-sloping Phillipscurve. There once was atime when someeconomists took this possibilityseriously, but data sincethe early 1970s have madethis simpleview untenable. Theinstability of this relationshipis hardly a surprise.Even Samuelson and Solow’s(1960)classic discussion ofthe Phillips curve suggested that theshort-run menu of in ation-unemploymentcombinations wouldlikely shift over time. Skep- ticsare sometimes tempted to use theshifting Phillips curve as evidenceto denythe existenceof a short-run tradeoff.This ispuresophistry. It wouldbe like observing that theUnited States has moreconsumption and investmentthan does India to denythat societyfaces atradeoffbetween consumption and investment.The situation isnot hard tounderstand and, infact, arisesfrequently in economics. At any point intime,society faces atradeoff,but thetradeoff changes overtime. The nextquestion is what factors cause thetradeoff to shift. Expectations,the Natural Rate and SupplyShocks SinceFriedman (1968) and Phelps ’s(1967,1968) seminal contributions, one variablehas playedcenter stage in explainingshifts inthe in ation-unemployment tradeoff:expected in ation. Otherthings equal,an increasein expectedin ation isassociated withan equalincrease in actual in ation. Thereason why expected in ation plays such aroledepends on thetheory of short-run nonneutrality. Moreover,the choice of theorywill in uencethe timing of when expectationsare formed.But from a bird ’s-eyeview, the similarity of thetheories is moresigni cant than theirdifferences. In moststandard theories,we can writethe in ation- unemploymenttradeoff as 5 e 2 a~U 2 U*!, where e isexpected in ation and U*isa parametercalled the “natural rateof 118Journal of Economic Perspectives unemployment. ” Thenatural rateis the rate of unemploymentthat prevailswhen in ation expectationsare con rmed.Seen in another light,the parameter U* embedsall shifts inthein ation-unemploymenttradeoff previously represented by theparameter k,otherthan shifts arisingfrom expected in ation. Thenatural ratecan beviewed as theunemployment rate that theeconomy reachesin the long run. This interpretationarises from imposing a modicumof rationalityto expectations. Over any longinterval of time,the average of expected in ation should equalthe average of actual in ation; otherwise,forecasts are systematicallybiased. Thus, overthe same long interval, average unemployment should equalthe average natural rate.In thelong run, U cannot deviatefrom U*. Noneof this means that thenatural rateof unemployment is immutable, or eventhat itmoves only slowly over time. In principle, U*can exhibitsubstantial high- frequencyvariation, so any othershift in thein ation-unemploymenttradeoff can bedescribed as ashiftin U*.As apracticalmatter, however, the literature on in ation-unemploymentdynamics has traditionallyused an amendedversion of the aboveequation: 5 e 2 a~U 2 U*! 1 v, where v isdubbed the “supply shock. ” Tosomeextent, the distinction between U* and v isarbitrary:both thenatural rate U*and thesupply shock v representshifts inthe in ation-unemployment tradeoff.But many economistsview these two variables as measuringdifferent kinds ofshifts. Thenatural rate U*isthought tore ecthow wellthe labor market matches workersand jobs. It isaltered,for instance, bychanges indemographicsor labor-marketinstitutions and isthought tomove slowly over time. By contrast, the supply shock v re ectsdisruptions inthe normal in ation process, such as that caused byan oilembargo or a change inthe exchange rate. The supply shock is thought toexhibit more high-frequency variation than thenatural rate. 1 Toimplementthis equation, somethinghas tobe said about how expectations areformed. One approach istoassume adaptiveexpectations, according towhich expected in ation isaweightedaverage of past in ation. Thesimplest version is to e positthat expectedin ation equalslast period ’s in ation: 5 2 1 . The in ation- unemploymenttradeoff then becomes 5 21 2 a~U 2 U*! 1 v. Therational expectations