History and Theory of the NAIRU:

A Critical Review

4 Federal Reser ve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 1997

An important element of this approach is the con- cept of a nonaccelerating inflation rate of unemployment, or NAIRU. As its name suggests, the NAIRU is supposed to be an unemployment rate (or range of unemployment rates) that produces a stable rate of inflation: if the unemployment rate is lower than the NAIRU then the inflation rate will tend to rise, and vice versa.

Recently, both the NAIRU and the theory of the inflation- unemployment relationship on which it is based have received a great deal of attention from the press. From December 1995 to December 1996, for example, there were ten articles on this subject in the Wall Street Journal, five articles in the New York Times, and three in The International Economy. One common feature of all these

articles is that they link Federal Reserve monetary policy to the NAIRU. Most of the authors seem to assume that the NAIRU is or should be the Fed’s principal guide for con- ducting monetary policy. According to this view, if the cur- rent unemployment rate is below some NAIRU estimate (say, 6 percent) then the Fed should tighten monetary pol- icy to head off a coming increase in the inflation rate.

Despite the extensive press coverage the NAIRU con- cept has received recently, the theory of the inflation- unemployment relationship that it is part of is quite controversial. Although the NAIRU is alive and well in the media and among economic policymakers, it is no longer very popular among academic economists. It has fallen out of favor partly because its conceptual foundation is

M A R C O A . E S P I N O S A – V E G A A N D S T E V E N R U S S E L L 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.

W 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

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.

5Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 1997

weak and partly because its empirical track record does not inspire confidence. Its survival is due largely to the fact that economists have not been able to reach any con- sensus about alternative guides for monetary policy.

The purpose of this article is to provide some histor- ical perspective on the “NAIRU theory” and the assump- tions behind it. Most of the analysis presented in this article is not original: it has been around for two decades or more. However, the recent resurgence of interest in the NAIRU indicates that there may be a need for a basic review of its origins and a brief explanation of some of the claims surrounding it. Readers interested in additional details should consult the reference list.

The first section of the discussion that follows briefly introduces the Keynesian and classical theories of macro- economics. Keynesian theory is the macroeconomic theo- ry on which the NAIRU is principally based while classical theory provides the foundation for the monetarist and neoclassical critiques of Keynesian theory that are dis- cussed at length in this article. As we shall see, the con- cept of a NAIRU grew out of economists’ attempts to reconcile the differences between Keynesian and mone- tarist theories on the subjects of the causes of price level changes and the relationship between inflation and unem- ployment. The next section discusses the Phillips curve, a description of the inflation-unemployment relationship that provided the empirical and theoretical starting points for the development of the NAIRU. The third section reviews the monetarist critique of analysis based on the Phillips curve and discusses a number of related ques- tions. The next two sections explain how the NAIRU devel- oped as a response to the monetarist critique of the Phillips curve and raise some basic questions about the NAIRU. The final part of the discussion reviews the con- cept of rational expectations, a theoretical contribution of neoclassical theory that amplified the monetarist critique of the Phillips curve. This section also discusses some neo- classical contributions that may offer alternatives to the Phillips curve approach to the study of inflation, unem- ployment, and the effects of monetary policy.

Two Economic Traditions

C lassical economic theory developed in the early 1900s, at a time when there was no formal distinc- tion between micro- and macroeconomics. The

theory was based on the same basic assumptions that had become widely used to study the behavior of individual households and firms. These included the assumptions that individuals usually act in ways that maximize their

self-interest, that prices are determined in the market- place, and that markets operate efficiently. According to classical theory, perfect competition is a good approxi- mation of the operation of most real-life markets. The basic assumptions of classical theory are generally under- stood to imply that government policies have relatively little importance in determining economic outcomes.

Keynesian theory, which developed in the 1930s and 1940s, was the first macroeconomic theory: it was designed specifically to study economywide phenomena, and it was not simply an extension of the conventional economic theory that continued to be used to study the behavior of individual parts and sectors of the economy. Keynesian theory was based on the work of John Maynard Keynes, a British economist who did most of his work in the 1920s and 1930s. One of the basic goals of Keynes’s theo- ry was to explain the persistently high rates of unemployment that appeared across the world during the Great Depression. Most of this unem- ployment was generally believed to be “involuntary,” in the sense that the unemployed people were willing to work at the going wage rates but were unable to find jobs. A close- ly related goal of Keynes was to identify steps that the gov- ernment could take to alleviate the high levels of unemployment.

Keynesian theory assumes that some important prices are determined or strongly influenced by forces outside the marketplace so that many markets may not be able to “clear” in the sense of successfully reconciling demand with supply. It also assumes that people may not always make the economic decisions that would be best for them. According to Keynesian theory, perfect compe- tition is not a good approximation of the operation of many important real-life markets. The theory implies that government policies can have large, important effects on the economy and that if the policies are carefully devised these effects can be very constructive in nature.1

Keynes’s ideas and goals placed him in direct con- 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.

The NAIRU has fallen out of favor among academic economists partly because its conceptual foundation is weak and partly because its empiri- cal track record does not inspire confidence.

6 Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 1997

Classical theory predicted that when unemployment was high wages would adjust downward, stimulating more hiring and reducing the unemployment rate. As a result, high unemployment could not last long. It seemed obvi- ous to Keynes (and many others) that the high, persis- tent levels of unemployment observed during the Depression were inconsistent with this prediction and that classical theory was incapable of explaining them. In 1933 prominent classical theorist A.C. Pigou published The Theory of Unemployment; according to Keynes, this book was “the only detailed account of the classical theo- ry of employment” in existence at the time. In his “Gen- eral Theory” article, Keynes dismisses Pigou’s book as “a non-causative investigation into the functional relation-

ship which determines w h a t l e v e l o f re a l wages will correspond to any given level of employment. . . . [It] is not capable of telling us what determines the actual level of employment; and on the problem of invol- untary unemployment it has no direct bear- ing” (1964, 275).

A c c o r d i n g t o K e y n e s , what pre- vented labor markets f r o m c l e a r i n g , a n d

explained involuntary unemployment, was that when firms’ demand for labor dec re a s e d , n o m i n a l (money) wages did not fall as fast or as far as classical theory pre- dicted.2 “Classical theory,” he comments, “has been accus- tomed to rest the supposedly self-adjusting character of the economic system on an assumed fluidity of money- wages” (1964, 257). Keynes believed that sluggish labor demand would not push nominal wages downward, at least in the short run. The logic behind this belief was that organized workers had enough market power to resist employers’ attempts to reduce money wage rates. As a result, Keynesian theory is often described as being based on the assumption of “sticky wages.”3 In the classi- cal model, unlike the Keynesian model, money wages and prices are assumed to be perfectly flexible, so labor mar- kets always clear. If temporary unemployment appears because of deficient aggregate demand, then the unem- ployed workers will bid down nominal wages until they have fallen far enough to eliminate the unemployment.

Keynes also criticized classical theory for failing to provide an integrated analysis of the behavior of different parts of the economy and for making an unwarranted leap from analysis of individual-industry labor markets to analysis of the determinants of aggregate employment.

He writes that “if the classical theory is not allowed to extend by analogy its conclusions in respect of a particu- lar industry to industry as a whole, it is wholly unable to answer the question what effect on employment a reduc- tion in money-wages will have. For it has no method of analysis wherewith to tackle the problem” (1964, 257).

Over time, it became clear that both classical and Keynesian theories suffered from some important defi- ciencies. Classical theorists needed to integrate their microeconomic theories of individual labor markets into a macroeconomic theory of total employment. They also needed to explain how government policies affected the labor market. The Keynesians needed to move in the opposite direction, integrating their macroeconomic the- ory with a microeconomic theory of labor markets and formalizing their explanation of wage-setting behavior.

The Phillips Curve

I nflation and Unemployment. In 1958 British econo- mist A.W. Phillips published the results of an empiri- cal analysis of historical data from the U.K. labor

market. Phillips’s study was intended to help answer one of the basic questions in macroeconomic theory, which concerns the cause of inflation. He hoped to find empiri- cal support for the Keynesian view that the rate of wage inflation—that is, the rate of increase in nominal (money) wage rates—depended on the tightness of the labor market. Since the level of unemployment was a readily observable indicator of the tightness of the labor market, Phillips’s immediate goal was “to see whether statistical evidence supports the hypothesis that the rate of change of money wage rates in the United Kingdom can be explained by the level of unemployment and the rate of change of unemployment” (1958, 284).

The logic behind Phillips’s theory is very simple. If for some reason the demand for labor were high relative to its supply—as in Atlanta during the Olympics, to use a modern example—then equilibrium wage rates would be expected to rise above current wage levels, and there would be upward pressure on nominal wages as firms bid for additional workers. As additional workers were actu- ally hired, moreover, the unemployment rate would fall. The larger the discrepancy between the quantity of labor demanded and the quantity supplied, the stronger the upward or downward pressure on wage rates. The oppo- site would be true when there was excess supply of labor and rising unemployment.

Phillips found, as he expected, that from 1861 to 1957 the growth rate of nominal wages was negatively correlated with the rate of unemployment—that is, low unemployment rates tended to be associated with rapidly rising wages while high unemployment rates were associ- ated with slowly rising wages. Phillips also found that the strength of the unemployment versus wage-change rela- tionship seemed to depend on the level of unemployment.

Classical economic theory was based on the assump- tions that individuals usually act in ways that maximize their self- interest, that prices are determined in the market- place, and that markets operate efficiently.

2. According to Keynes, the principal source of the observed fluctuations in labor demand was the volatility of aggregate invest- ment. Investment volatility, in turn, was caused by changes in short- and long-term business expectations and variation in interest rates.

3. The discussion will show that the stickiness assumption was also extended to aggregate prices. 4. Phillips was not the first researcher to turn up findings of this general sort. As long ago as 1926 Irving Fisher had found a neg-

ative correlation between the rate of goods-price inflation and the level of unemployment. 5. If workers in New York City and rural Mississippi both make $2,500 per month, the worker in rural Mississippi will have a much

higher real wage because the cost of living is lower there.

7Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 1997

When unemployment was low, decreases in unemploy- ment tended to be associated with big increases in wage inflation while when unemployment was high, decreases in the unemployment rate seemed to produce small increases in wage growth rates (see Chart 1 for a hypo- thetical Phillips curve). These findings appeared to con- firm Keynes’s theory of the downward stickiness of nominal wages. Tight labor markets seemed to cause employers to bid wages up rapidly while loose markets (high unemployment) seemed to cause workers to bid wages down relatively slowly.

Phillips’s findings have had a profound and lasting effect on economists’ ideas about the relationship between inflation and unemployment. What made them so interesting is that they seemed to establish a clear linkage between the state of the labor market and the rate of inflation. By the early 1960s, inflation rates in the United States and western Europe had increased to the point that inflation was coming to be regarded as a seri- ous economic problem. As a result, economists and poli- cymakers were eager for information about its possible causes and potential cures. The Phillips curve appeared to link the real and nominal sides of the economy.4

One possible objection to the conclusions that Phillips (and others) drew from his findings is that stan- dard economic theory predicts that what matters to work- ers is not their nominal wages but their real, or inflation-adjusted, wages.5 Phillips did not attempt to measure real wages or study their statistical relationship to unemployment. Under the Keynesian assumption of predetermined or sticky nominal prices, however, changes in expected real and nominal wages would coin- cide. In addition, while Phillips’s statistical evidence involved changes in current nominal wages, the hypothe- sis that he was trying to test involved changes in expect- ed nominal wages. If workers were slow to adjust their price expectations to actual price changes, changes in current nominal wages could be interpreted as changes in expected real wages.

Another problem with Phillips’s findings is that they involve wage inflation while economists were principally concerned about explaining price inflation. Since wages are the biggest single component of firms’ costs, however, most economists were willing to assume that persistent increases in wage rates would eventually force firms to begin increasing their prices, producing economywide

price inflation. For this explanation for inflation to make sense, however, it was necessary to make even more elab- orate assumptions about stickiness: wages now had to be assumed to adjust faster than goods prices, at least when wages were rising. (In conventional Keynesian theory, nominal wages were supposed to be slow to fall when a decrease in aggregate demand put downward pressure on prices; the result was a higher-than-equilibrium real wage and involuntary unemployment.)

How was the Phillips curve related to monetary pol- icy? Keynesian theory held that monetary policy could be used to increase or decrease the economy’s aggregate demand—the total nominal demand for goods and ser- vices of all types—and through it the aggregate level of employment in the economy. The Phillips curve mecha- nism explained how aggregate demand management could affect the rate of inflation. Thus, economic policy- makers began to think in terms of a trade-off between the unemployment rate and inflation rate. Although gov- ernment aggregate-demand stimulus was no longer cost- free, as it had been in traditional Keynesian theory (which had viewed the price level as constant), it was still possible for the policy authority to reduce the level of employment if it was willing to tolerate the resulting increase in inflation along the Phillips curve. As the next section will show, another reason for the popularity of

C H A R T 1 The Phillips Curve

The now-conventional Phillips curve diagram has the unemployment rate on the horizontal axis and the inflation rate on the vertical axis.

U n e m p l o y m e n t R a t e

I n

f l a

t i o

n R

a t

e

8 Federal Reser ve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 1997

the Phillips curve is that it was seen by some prominent economists as providing a synthesis of competing theo- ries of inflation.

Cost-Push versus Demand-Pull Inflation. At the time the Phillips curve analysis appeared, economists’ interest in understanding the relationship between wages, prices, and economic activity had been growing for some time, and there was also growing interest in studying the effects of government policies on this relationship. Samuelson and Solow (1960) provide a comprehensive review of the debate on these questions that took place after the Second World War. The debate centered on two basic theories of the causes of inflation: demand-pull and cost-push. Both theories can be explained using the aggregate-demand/aggregate-supply model of output and price level determination that was developed during the 1950s and remains popular in textbooks. Demand-pull inflation resulted from increases in the level of aggregate demand that occurred at or near the point of full capaci- ty utilization—that is, at points at which the aggregate supply curve was upward-sloping rather than flat. Cost- push inflation, on the other hand, was caused by upward shifts in the aggregate supply curve. These shifts could allow wages and prices to rise even before full employ- ment was reached.6

According to Samuelson and Solow, there were real- ly no purists in this debate. Most economists believed that inflation had both demand-pull and cost-push com- ponents, but they differed as to which component pre- dominated. Thus, although demand-pull inflation was associated with Keynesian theory, Keynes himself did not dismiss the cost-push hypothesis. He was “willing to assume that attainment of full employment would make prices and wages flexible upward. . . . Just as wages and prices may be sticky in the face of unemployment and overcapacity, so may they be pushing upward beyond what can be explained in terms of levels and shifts in demand” (1964, 180-81).

Samuelson and Solow believed that in order to rec- oncile the two sides of this debate it would be necessary for economists to improve their understanding of the behavior of money wages with respect to the level of employment. They saw the Phillips curve as a useful tool for analyzing this behavior. Under some conditions, they explained, “movements along the Phillips curve might be dubbed standard demand-pull, and shifts of the Phillips curve might represent the institutional changes on which cost-push theories rest” (1960, 189).

The Monetarist Challenge to the Keynesian Approach

T he Acceleration Hypothesis. One prominent U.S. economist who was skeptical of Keynesian theory in general, and of Phillips curve analysis in partic-

ular, was Milton Friedman. Friedman was the champion

of monetarism, a theory that saw inflation as always and everywhere a monetary phenomenon. He was also rather skeptical of the Keynesian view that demand-management policy could have significant effects on output or employ- ment. Beginning in the mid-1960s, Friedman began to challenge some of the conclusions about the inflation- unemployment relationship that economists writing in the 1960s and early 1970s were drawing on the basis of Keynesian theory.