Ditch the NAIRU!

24 Sep, 2014 at 21:41 | Posted in Economics | 5 Comments

The most important implication of [the conventional NAIRU equation], however, is that there is no role whatsoever for demand factors in determining equilibrium unemployment. Any attempts by fiscal or monetary policy to permanently move (actual) unemployment away from its equilibrium level u* is doomed to failure. Policy may succeed in temporarily lowering unemployment, thus causing inflation, which in turn will undermine demand and raise unemployment until the equilibrium or “natural” rate of unemployment is reached again.


Demand will adjust itself to the “natural” level of output, corresponding to the rate of equilibrium unemployment, either passively through the so-called real balance effect or, alternatively, more actively through a policy-administered rise in interest rates; in the latter case, actual unemployment is determined by how large the central bank thinks the NAIRU is. The implication of [the conventional NAIRU equation] is that employment policy should focus exclusively on the labor market (and not on aggregate demand and investment), and above all on the behavior of labor unions and (mostly welfare state-related) wage–push factors. The policy recommendations are straightforward: to reduce unemployment, labor markets have to be deregulated; employment protection, labor taxes, and unemployment benefits have to be reduced; wage bargaining has to be decentralized; and welfare states have to be scaled down … However, although the view that labor market regulation explains OECD unemployment has become widely accepted, particularly in policy circles, it is by no means universally accepted. Serious problems remain …

Even authors working within the orthodox NAIRU approach are unable to explain (changes in long-run) unemployment in terms of only “excessive” labor market regulation. To explain (changes in) u*, most empirical studies consider it necessary to include other, additional “factors which might explain short-run deviations of unemployment from its equilibrium level” … the most important of which are aggregate demand shocks (i.e., import price and real interest rate shocks) and productivity shocks. The inclusion of such “shocks” is not an innocent amendment, because it turns out that a significant part of the OECD unemployment increase during the past three decades must be attributed to these shocks … This is obviously a dissatisfactory state of affairs: in the theoretical analysis,the impact of demand factors on equilibrium unemployment is defined away, but in the empirical analysis it has to be brought back in, not as a structural determinant but rather as an exogenous shock. We argue that this incongruence points to a misspecification of the NAIRU model.

Servaas Storm & C. W. M. Naastepad


  1. Why Not Shockfull Empoyment by William S. Vickrey ,1994

    Click to access 77164002.pdf

  2. Ralph i think you are wrong, it is not only a appeal to emotion to bring up such as poverty,homelessness family breakups,as it´s also in pure, economic terms,is a gross waste of resources, a huge net loss.But as i understand it you are familliar with Abba Lerner,what do you think about the fact that Milton Friedman,the so called “inventor” of the NAIRU,as fare as i know never mention, that the ideas of an NAIRU was first brought up by Abba Lerner,long before Friedman.Since he know Abba Lerner personally he must been aware of Lerner´s work on that area.It seem to me that Milton Friedman ,had an consistent habit to bring up ideas,that people long before him had developed,without pay the hommage to the real fathers.

  3. Vickrey’s appeals to emotion (“poverty, homelessness, family breakups…”) are ridiculous.

    His argument seems to be: “accepting NAIRU means accepting unemployment, and unemployment is nasty, ergo NAIRU must be an invalid idea”. You might as well argue that cancer is a nasty disease, therefor cancer doesn’t exist.

  4. William Spencer Vickrey ,Columbia University
    awarded the 1996 Nobel Memorial Prize in Economic Sciences-

    “Fifteen Fatal Fallacies of Financial Fundamentalism: A Disquisition on Demand Side Economics-1996 ”

    “Fallacy 6

    It is thought necessary to keep unemployment at a “non-inflation-accelerating” level (“NIARU”) in the range of 4% to 6% if inflation is to be kept from increasing unacceptably.

    Currently the unemployment rate as officially measured has fallen to 5.1%, while the Congressional Budget Office (CBO) has put the NIARU for 1964 at 6.0 percent, having ranged between 5.5 and 6.3 since 1958. Recent CBO protections were for unemployment to remain steady at 6.0 percent through the year 2005, with inflation in the urban consumer price index fairly steady at about 3.0 percent (Economic and Budget Outlook, May 1996, pp xv, xvi, 2, 3).

    This may be a fairly optimistic forecast of the results to be expected from current tendencies, but as a goal it is simply intolerable. While even five percent unemployment might be barely acceptable if it meant a compulsory extra two weeks of unpaid furlough annually for everyone, it is totally unacceptable when it means 10%, 20% and 40% unemployment among disadvantaged groups, with serious consequences for poverty, homelessness, family breakups, drug addiction and crime. The malaise that pervades our cities may be attributable in no small measure to the fact that for the first time in our history, an entire generation and more has grown up without experiencing reasonably full employment, even briefly. In contrast, while most other industrialized countries are currently experiencing higher rates of unemployment than the U.S., they have nearly all had relatively recent periods of close to full employment. Unemployment insurance and other welfare programs have also been much more generous so that the sociological impacts have been much less demoralizing.

    The underlying assumption that there is an exogenous NIARU imposing an unavoidable constraint on macroeconomic possibilities is open to serious question on both historical and analytical grounds. Historically, the U.S. enjoyed an unemployment rate of 1.8% for 1926 as a whole with the price level falling, if anything. West Germany enjoyed an unemployment rate of around 0.6% over the several years around 1960, and most developed countries have enjoyed episodes of unemployment under 2% without serious inflation. Thus a NIARU, if it exists at all, must be regarded as highly variable over time and place. It is not clear that estimates of the NIARU have not been contaminated by failure to allow for a possible impact of inflation on employment as well as the impact of unemployment on inflation. A Marxist interpretation of the insistence on a NIARU might be as a stalking horse to enlist the fear of inflation to justify the maintenance of a “reserve army of the unemployed,” allegedly to keep wages from initiating a “wage-price spiral.” One never hears of a “rent-price spiral”, or an “interest-price spiral,” though these costs are also to be considered in the setting of prices. Indeed when the FRB raises interest rates in an attempt to ward off inflation, the increase in interest costs to merchants may well trigger a small price increase.

    Analytically, it would be more rational to expect that there could be a maximum non inflation-accelerating rate of reduction of unemployment (NIARRU), such that if an attempt were made to proceed more rapidly by a greater recycling of excess savings into purchasing power through government deficits, prices would start to rise more rapidly than had been generally anticipated. This would occur as a result of a failure of supply to keep up with the increased demand, giving rise to shortages and the dissipation of part of the increased demand into more rapidly rising prices. This NIARRU may be determined by limits to the rates at which labor can be hired and put to work to meet anticipated increases in demand, and perhaps lags in the realization that demand will be increased, and even new productive facilities created, installed, and brought up to speed. The ultimate technological constraint to putting unemployed to work more rapidly in the private sector may reside in a limited capacity in the capital goods industries such as construction, cement, and machine tools.

    In any case much will depend on the degree of confidence that can be engendered in the proposed increase in demand. It might be wise to start slowly, with a reduction of unemployment by say 0.5% the first year, and increasing to say 1% per year as confidence is gained. Possibly the growth rate should subsequently be reduced somewhat as full employment is approached, allowing for the increasing difficulty of matching workers to vacancies. It is mainly at the later stages of the approach to full employment that training and improving the organization of the labor market may become needed. In the face of a policy of maintaining a fixed NIARU, “workfare” efforts to retrain and assist welfare clients amount to assistance in the playing of a cruel game of musical chairs.

    Such a NIARRU is likely to prove somewhat volatile and difficult to predict, and in any case it might prove desirable to push to full employment somewhat faster than would be permitted by an unaltered NIARRU. This would call for the introduction of some new means of inflation control that does not require unemployment for it to be effective. Indeed, if we are to control three major macroeconomic dimensions of the economy, namely the inflation rate, the unemployment rate, and the growth rate, a third control is needed that will be reasonably non-collinear in its effects to those of a fiscal policy operating through disposable income generation on the one hand, and monetary policy operating through interest rates on the other.

    What may be needed is a method of directly controlling inflation that do not interfere with free market adjustments in relative prices or rely on unemployment to keep inflation in check. Without such a control, unanticipated changes in the rate of inflation, either up or down, will continue to plague the economy and make planning for investment difficult. Trying to control an economy in three major macroeconomic dimensions with only two instruments is like trying to fly an airplane with elevator and rudder but no ailerons; in calm weather and with sufficient dihedral one can manage if turns are made very gingerly, but trying to land in a cross-wind is likely to produce a crash.

    One possible third control measure would be a system of marketable rights to value added, (or “gross markups”) issued to firms enjoying limited liability, proportioned to the prime factors employed, such as labor and capital, with an aggregate face value corresponding to the overall market value of the output at a programmed overall price level. Firms encountering a specially favorable market could realize a higher than normal level of markups only by purchasing rights from firms less favorably situated. The market value of the rights would vary automatically so as to apply the correct downward pressure on markups to produce the desired overall price level. A suitable penalty tax would be levied on any firm found to have had value added in excess of the warrants held.

    In any case it is important to keep in mind that divergences in the rate of inflation either up or down, from what was previously expected, produce merely an arbitrary redistribution of a given total product, equivalent at worst to legitimized embezzlement, unless indeed these unpredictable variations are so extreme and rapid as to destroy the usefulness of currency as a means of exchange. Unemployment, on the other hand, reduces the total product to be distributed; it is at best equivalent to vandalism, and when it contributes to crime it becomes the equivalent of homicidal arson. In the U.S. the widespread availability of automatic teller machines in supermarkets and elsewhere would make the “shoe-leather cost” of a high but predictable inflation rate quite negligible.”

  5. why don’t you ever post Roger Farmer’s stuff? He has been on this anti-Nairu crusade for a while now. Granted I often don’t understand what he is getting at, but still….

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