7+(1$,58&21&(37±0($685(0(17 81&(57$,17,(6+<67(5(6,6$1'(&2120,& 32/,&<52/( 30&$'$0$1'.0&02552: 7$%/(2)&217(176 ,QWURGXFWRU\5HPDUNV &KDSWHUUncertainties concerning model selection : A number of plausible modelling approaches exist for Measuring the NAIRU 1.1 Univariate Methods / Models 1.2 Variants of the Expectations Augmented Phillips Curve Approach &KDSWHUProduction of NAIRU estimates for the US, Japan and EU- 15 using a Conventional Bargaining model approach &KDSWHU Empirical Inadequacies : Uncertainties surrounding the NAIRU Point Estimates 3.1 Confidence Intervals 3.2 Results from US and Canadian NAIRU studies &KDSWHU Theoretical Weaknesses : The Notion of Hysteresis Complicates the Interpretation of Changes in the NAIRU &KDSWHU The Nairu Concept, its Phillips Curve Origins and its Evolution in terms of the Economic Policy Debate &RQFOXGLQJ5HPDUNV 2 7+(1$,58&21&(37±0($685(0(17 81&(57$,17,(6+<67(5(6,6$1' (&2120,&32/,&<52/( ,1752'8&725<5(0$5.6 In 1968 Friedman put forward the notion of a “natural” rate of unemployment to encapsulate the idea that a “normal” level of unemployment, roughly equivalent to the amount of frictional and structural unemployment, persists even when the labour market is in equilibrium. Since there are no direct measures of the natural rate, as it is essentially a theoretical construct, one must be satisfied with proxy estimates derived using various methods including that which draws on Tobin’s concept of the non- accelerating inflation rate of unemployment(i.e. the NAIRU). This latter concept has been used extensively since the 1970s to show that policy makers are not in a position to buy permanent reductions in unemployment by tolerating a higher rate of inflation. Once expectations have fully adapted to any new expansionary policy regime, unemployment will ultimately return to that level of unemployment required to hold inflation steady i.e. the NAIRU. Deviations from the NAIRU or natural rate could only be maintained at the cost of continuously accelerating or decelerating wage increases with the former leading to the well-known phenomenon of wage-price spirals. The concept of the NAIRU should therefore be seen in the context of the shift in the framework for analysis of the labour market over the last number of decades from one focussed on whether the labour market clears or not, to one which allows for imperfectly competitive goods markets and recognises that unions have a role to play in terms of wage determination. This shift to a bargaining framework of wage setting under imperfect competition is likely to lead to a NAIRU estimate which converges to an unemployment rate which is higher, because of the monopolistic element, compared with that under the classical competitive paradigm and its theoretically equivalent concept of the natural rate. The present paper looks at this notion of a NAIRU and asks whether it continues to stand up to rigorous analysis in terms of both its theoretical underpinnings or of its empirical applicability. The paper addresses the essential questions in relation to an examination of the NAIRU, namely • 1. Can it be reliably calculated ? and • 2. Does the concept continue to have any relevance in terms of the micro and macro policy debate ? In relation to the first question, it is stressed that precise measurements of the NAIRU are extremely difficult to produce because any measurement process is dogged by the existence of two fundamental sources of uncertainty. The first source of uncertainty 3 emanates from the fact that the NAIRU must be estimated since it is unobserved, with many different modelling approaches and empirical specifications from which to choose, all of which give plausible, although different, point measurements of the NAIRU. Amongst the competing approaches a preference is shown for the bargaining model method, with the latter being used to produce NAIRU estimates for the US, Japan and the EC15. The second source of uncertainty is the degree of doubt surrounding the NAIRU point estimates themselves, which are imprecisely calculated from a combination of stochastic variables and parameters, with the computing of confidence intervals for the latter highlighting the extent of the imprecision of the various methods used in the calculation. This latter issue of confidence interval estimation is discussed in detail, with the results of the various calculation methods being presented. As regards the second question, following a discussion on the history of the NAIRU, which stresses its Phillips Curve origins and its role in the policy debates over the last three decades, the paper goes on to discuss the issue of the continuing policy relevance of the concept. In this regard, the growing unease, openly articulated in the vast literature on this topic, concerning both the theoretical and empirical underpinnings of the NAIRU, suggests caution needs to be exercised in terms of any policy role being attributed to the concept. At a fundamental level the theoretical weaknesses, in particular hysteresis mechanisms, call into question the existence of a unique long run NAIRU, i.e. it may be indeterminate or stochastic by nature. At a more practical level, as mentioned above, the existence of a multitude of different point estimates due to model selection/specification differences allied to wide confidence intervals for all of the individual point estimates produced must instil a strong sense of dubiousness in the minds of policy makers. The paper tentatively concludes that while theoretically the NAIRU is still a useful concept its extensive empirical inadequacies render it less than useful in the macro policy context, although a case can still be made for sustaining its use as a structural indicator for cross country, labour flexibility, comparisons. 4 &+$37(5 81&(57$,17,(6 &21&(51,1* 02'(/ 6(/(&7,21 $ 180%(5 2) 3/$86,%/( 02'(//,1* $3352$&+(6 (;,67 )25 0($685,1*7+(1$,58 There are two broad modelling approaches normally adopted in defining the NAIRU, the expectations-augmented Phillips curve approach, which distinguishes a series of labour market variables as potential empirical determinants of the NAIRU, and the atheoretical univariate framework method in which the time series properties of the macroeconomic variable in question are used to identify the NAIRU. 81,9$5,$7( 0(7+2'6 02'(/6: Univariate methods are essentially statistical as opposed to economic models of the NAIRU, with the underlying assumption being that unemployment always reverts to its mean or natural rate over time. If the latter assumption is true then the NAIRU can be defined uniquely in terms of the behaviour of the unemployment series itself. Conceptually, in terms of the dynamics of unemployment, most time series methods for constructing NAIRU estimates break down the unemployment rate into a deterministic or trend component, which is understood to represent the NAIRU, and a stochastic or cyclical element. Changes in the deterministic component of unemployment could be interpreted as occurring as a result of structural breaks or regime changes which have the effect of shifting the equilibrium rate of unemployment from time to time; for example the widespread adoption of non-accommodating policies in the early 1980s is often represented as a policy regime change which could have fundamentally modified wage determination relationships and consequently the NAIRU. A radically different interpretation is also possible, based on the notion of hysteresis mechanisms operating in the labour market, which suggests that there is no equilibrium level to which unemployment reverts to in the long run i.e. equilibrium unemployment rates may be non-stationary in that they follow a stochastic or indeterminate trend. Adopting this latter interpretation would suggest that the NAIRU is history dependent in that it is heavily influenced by the historical evolution of actual unemployment. ,681(03/2<0(17$67$7,21$5<2512167$7,21$5<352&(66" : Since inflation has been stable in Europe for some years now one could, in theory, make a case for suggesting that the prevailing rate of unemployment in Europe is close to, or equal to, its natural rate. However, this is only true if the unemployment series itself is a stationary one. Since the unemployment series in Europe may be non-stationary (i.e. it may not be mean reverting or it may be very slowly mean reverting due to the influence of slow adjustment mechanisms in the labour market) then it may be difficult to estimate a long-run NAIRU since although the present rate of inflation may be stable, the unemployment rate may or may not be. Consequently, this distinction between stationary and non-stationary series is an important one and depends on whether or not the variable contains a unit root. Testing the US and EC15 unemployment series for the presence of a unit root can be carried out in several ways with the augmented Dickey- Fuller (ADF) and Phillips- Perron (PP) tests being adopted for the present exercise. In testing for the presence of a unit root, it is necessary to allow both an intercept and a time trend to enter the 5 regression model. The null hypothesis to be tested is that the unemployment time series is non-stationary (i.e. it contains a unit root) against the alternative hypothesis of stationarity. ADF and PP statistics for the US and EC15 unemployment rates are shown in Table 1 and when compared with the MacKinnon critical values clearly suggest that for both areas, the unemployment series are non-stationary, although the US comes much closer than the EU to rejecting the null hypothesis. This latter distinction between the two areas is corroborated in Graph 1 which shows trend unemployment1 for both geographical zones, with the EU15 trend appearing to drift upwards from cycle to cycle whereas the US appears to be moving back to its mean 1970’s value in the present decade.