NAIRU religion

13 June, 2016 at 09:45 | Posted in Economics | 1 Comment

Having concluded seven years as chief economist at IMF, Olivier Blanchard is now considering rewriting his undergraduate macroeconomics textbook:

How should we teach macroeconomics to undergraduates after the crisis? Here are some of my conclusions …

Turning to the supply side, the contraption known as the aggregate demand–aggregate supply model should be eliminated. It is clunky and, for good reasons, undergraduates find it difficult to understand … These difficulties are avoided if one simply uses a Phillips Curve (PC) relation to characterize the supply side. Potential output, or equivalently, the natural rate of unemployment, is determined by the interaction between wage setting and price setting. Output above potential, or unemployment below the natural rate, puts upward pressure on inflation. The nature of the pressure depends on the formation of expectations, an issue central to current developments. jobs%20cartoonIf people expect inflation to be the same as in the recent past, pressure takes the form of an increase in the inflation rate. If people expect inflation to be roughly constant as seems to be the case today, then pressure takes the form of higher—rather than increasing—inflation. What happens to the economy, whether it returns to its historical trend, then depends on how the central bank adjusts the policy rate in response to this inflation pressure.

Hmm …

One of the main problems with NAIRU — what Blanchard is referring to as ‘the natural rate of unemployment’ — is that if it is essentially seen as a timeless long-run equilibrium attractor to which actual unemployment (allegedly) has to adjust, then if that equilibrium is itself changing — and in ways that depend on the process of getting to the equilibrium — well, then we can’t really be sure what that equlibrium will be without contextualizing unemployment in real historical time. And when we do, we will see how seriously wrong we go if we omit demand from the analysis. Demand policy has long-run effects and matters also for structural unemployment — and governments and central banks can’t just look the other way and legitimize their passivity re unemployment by refering to NAIRU.

NAIRU does not hold water simply because it does not exist, and to base economic policy — or textbook models — on such a weak theoretical and empirical construct is nothing short of writing out a prescription for self-inflicted economic havoc.

According to the  [NAIRU theory], unemployment differs from its natural rate only if expected inflation differs from actual inflation. If expectations are rational, we should see as many quarters when inflation is above expected inflation as quarters when it is below expected inflation. That suggests the following test of the [NAIRU theory]..

74-7495-LTNQ100ZBecause a decade contains 40 quarters, the probability that average expected inflation over a decade will be different from naverage actual inflation should be small. If the [NAIRU theory] and rational expectations are both true simultaneously, a plot of decade averages of inflation against unemployment should reveal a vertical line at the natural rate of unemployment … This prediction fails dramatically.

There is no tendency for the points to lie around a vertical line and, if anything, the long-run Phillips is upward sloping, and closer to being horizontal than vertical. Since it is unlikely that expectations are systematically biased over decades, I conclude that the  [NAIRU theory] is false.

Defenders of the [NAIRU theory] might choose to respond to these empirical findings by arguing that the natural rate of unemployment is time varying. But I am unaware of any theory which provides us, in advance, with an explanation of how the natural rate of unemployment varies over time. In the absence of such a theory the [NAIRU theory] has no predictive content. A theory like this, which cannot be falsified by any set of observations, is closer to religion than science.

Roger Farmer

1 Comment

  1. “NAIRU does not hold water simply because it does not exist.” Well stated. Even I can follow that logic.

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