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History and Theory of the NAIRU: a Critical Review

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History and Theory of the NAIRU: a Critical Review History and Theory of the NAIRU: A Critical Review MARCO A. ESPINOSA-VEGA AND STEVEN RUSSELL Espinosa is a senior economist at the Federal Reserve Bank of Atlanta. Russell is an assistant professor of economics at Indiana University-Purdue University at Indianapolis. They thank, without implicating, Eric Leeper, Maurice Obstfeld, Mary Rosenbaum, and Charles Whiteman for preliminary conversations on the topic and Bob Eisenbeis and Robert Bliss for helpful expositional comments on the final draft. HAT CAUSES CHANGES IN THE RATES OF INFLATION AND UNEMPLOYMENT? HOW ARE THE PRICE LEVEL AND THE LEVEL OF EMPLOYMENT RELATED? THESE HAVE BEEN KEY QUESTIONS FACING ECONOMISTS FOR AT LEAST FORTY YEARS. DISCUSSIONS ABOUT W THEM IN THE PRESS AND ELSEWHERE OFTEN CENTER ON AN APPROACH TO EXPLAINING THE INFLATION-UNEMPLOYMENT RELATIONSHIP THAT DATES BACK TO THE 1960S AND 1970S. ACCORDING TO THIS APPROACH, INFLATION IS CAUSED BY AN EXCESSIVELY TIGHT LABOR MARKET THAT DRIVES UP WAGES AND FORCES FIRMS TO RESPOND BY RAISING PRICES. An important element of this approach is the con- articles is that they link Federal Reserve monetary policy cept of a nonaccelerating inflation rate of unemployment, to the NAIRU. Most of the authors seem to assume that the or NAIRU. As its name suggests, the NAIRU is supposed to NAIRU is or should be the Fed’s principal guide for con- be an unemployment rate (or range of unemployment ducting monetary policy. According to this view, if the cur- rates) that produces a stable rate of inflation: if the rent unemployment rate is below some NAIRU estimate unemployment rate is lower than the NAIRU then the (say, 6 percent) then the Fed should tighten monetary pol- inflation rate will tend to rise, and vice versa. icy to head off a coming increase in the inflation rate. Recently, both the NAIRU and the theory of the inflation- Despite the extensive press coverage the NAIRU con- unemployment relationship on which it is based have cept has received recently, the theory of the inflation- received a great deal of attention from the press. From unemployment relationship that it is part of is quite December 1995 to December 1996, for example, there were controversial. Although the NAIRU is alive and well in the ten articles on this subject in the Wall Street Journal, five media and among economic policymakers, it is no longer articles in the New York Times, and three in The very popular among academic economists. It has fallen International Economy. One common feature of all these out of favor partly because its conceptual foundation is 4 Federal Reserve Bank of Atlanta ECONOMIC REVIEW Second Quarter 1997 weak and partly because its empirical track record does self-interest, that prices are determined in the market- not inspire confidence. Its survival is due largely to the place, and that markets operate efficiently. According to fact that economists have not been able to reach any con- classical theory, perfect competition is a good approxi- sensus about alternative guides for monetary policy. mation of the operation of most real-life markets. The The purpose of this article is to provide some histor- basic assumptions of classical theory are generally under- ical perspective on the “NAIRU theory” and the assump- stood to imply that government policies have relatively tions behind it. Most of the analysis presented in this little importance in determining economic outcomes. article is not original: it has been around for two decades Keynesian theory, which developed in the 1930s and or more. However, the recent resurgence of interest in the 1940s, was the first macroeconomic theory: it was NAIRU indicates that there may be a need for a basic designed specifically to study economywide phenomena, review of its origins and a brief explanation of some of the and it was not simply an extension of the conventional claims surrounding it. Readers interested in additional economic theory that details should consult the reference list. continued to be used to The first section of the discussion that follows briefly study the behavior of introduces the Keynesian and classical theories of macro- individual parts and The NAIRU has fallen out economics. Keynesian theory is the macroeconomic theo- sectors of the economy. ry on which the NAIRU is principally based while classical Keynesian theory was of favor among academic theory provides the foundation for the monetarist and based on the work of economists partly neoclassical critiques of Keynesian theory that are dis- John Maynard Keynes, because its conceptual cussed at length in this article. As we shall see, the con- a British economist cept of a NAIRU grew out of economists’ attempts to who did most of his foundation is weak and reconcile the differences between Keynesian and mone- work in the 1920s and partly because its empiri- tarist theories on the subjects of the causes of price level 1930s. One of the basic cal track record does not changes and the relationship between inflation and unem- goals of Keynes’s theo- ployment. The next section discusses the Phillips curve, a ry was to explain the inspire confidence. description of the inflation-unemployment relationship persistently high rates that provided the empirical and theoretical starting points of unemployment that for the development of the NAIRU. The third section appeared across the reviews the monetarist critique of analysis based on the world during the Great Depression. Most of this unem- Phillips curve and discusses a number of related ques- ployment was generally believed to be “involuntary,” in the tions. The next two sections explain how the NAIRU devel- sense that the unemployed people were willing to work at oped as a response to the monetarist critique of the the going wage rates but were unable to find jobs. A close- Phillips curve and raise some basic questions about the ly related goal of Keynes was to identify steps that the gov- NAIRU. The final part of the discussion reviews the con- ernment could take to alleviate the high levels of cept of rational expectations, a theoretical contribution of unemployment. neoclassical theory that amplified the monetarist critique Keynesian theory assumes that some important of the Phillips curve. This section also discusses some neo- prices are determined or strongly influenced by forces classical contributions that may offer alternatives to the outside the marketplace so that many markets may not Phillips curve approach to the study of inflation, unem- be able to “clear” in the sense of successfully reconciling ployment, and the effects of monetary policy. demand with supply. It also assumes that people may not always make the economic decisions that would be best Two Economic Traditions for them. According to Keynesian theory, perfect compe- lassical economic theory developed in the early tition is not a good approximation of the operation of 1900s, at a time when there was no formal distinc- many important real-life markets. The theory implies that Ction between micro- and macroeconomics. The government policies can have large, important effects on theory was based on the same basic assumptions that had the economy and that if the policies are carefully devised become widely used to study the behavior of individual these effects can be very constructive in nature.1 households and firms. These included the assumptions Keynes’s ideas and goals placed him in direct con- that individuals usually act in ways that maximize their flict with the exponents of the reigning classical theory. 1.The monetarist and neoclassical theories developed later—monetarism in the 1950s and neoclassical theory in the 1970s. These theories were developed as alternatives to Keynesian theory, which was then accepted by most contemporary economists. Both theories drew heavily on the classical tradition. As we shall see, the economic theory behind the NAIRU is basically Keynesian in nature, but it has been influenced heavily by monetarist ideas and to a lesser extent by neoclassical ones. Federal Reserve Bank of AtlantaECONOMIC REVIEW Second Quarter 1997 5 Classical theory predicted that when unemployment was He writes that “if the classical theory is not allowed to high wages would adjust downward, stimulating more extend by analogy its conclusions in respect of a particu- hiring and reducing the unemployment rate. As a result, lar industry to industry as a whole, it is wholly unable to high unemployment could not last long. It seemed obvi- answer the question what effect on employment a reduc- ous to Keynes (and many others) that the high, persis- tion in money-wages will have. For it has no method of tent levels of unemployment observed during the analysis wherewith to tackle the problem” (1964, 257). Depression were inconsistent with this prediction and Over time, it became clear that both classical and that classical theory was incapable of explaining them. In Keynesian theories suffered from some important defi- 1933 prominent classical theorist A.C. Pigou published ciencies. Classical theorists needed to integrate their The Theory of Unemployment; according to Keynes, this microeconomic theories of individual labor markets into book was “the only detailed account of the classical theo- a macroeconomic theory of total employment. They also ry of employment” in existence at the time. In his “Gen- needed to explain how government policies affected the eral Theory” article, Keynes dismisses Pigou’s book as “a labor market. The Keynesians needed to move in the non-causative investigation into the functional relation- opposite direction, integrating their macroeconomic the- ship which determines ory with a microeconomic theory of labor markets and what level of real formalizing their explanation of wage-setting behavior. wages will correspond Classical economic theory to any given level of The Phillips Curve was based on the assump- employment. [It] is nflation and Unemployment.In 1958 British econo- tions that individuals not capable of telling mist A.W.
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