The NAIRU: a critical appraisal

Abstract

This paper is concerned with the question of the relevance of the NAIRU for policy formulation. However, that question leads to the following consideration. The estimates for the NAIRU are based on the econometric estimation of models of the economy. Particular models are used and particular interpretations are placed on the relationship between the variables which the model involves. Since the NAIRU can never be directly observed, resort has to be made to the econometric estimation of wage and price equations from which an equilibrium solution for unemployment is derived and labeled the NAIRU. It is therefore important to know how valid those models are and the estimates derived from those models. Whilst some have pointed to the unreliability of those estimates (e.g. Setterfield et alia, 1992) and others to the degree of uncertainty surrounding the estimates (e.g. Madsen, 1997), others have put a great deal of faith in specific estimates: for example the ‘Tightness in the labor market is measured by the excess of CBO's estimate of the non accelerating inflation rate of unemployment (NAIRU) over the actual unemployment rate. It is an indicator of future wage inflation' (Congressional Budget Office, 1994, p. 4), and that Office uses an estimate of 6 percent for the NAIRU. One expression of the belief in the NAIRU is given by Stiglitz when he writes that ‘I have become convinced that the NAIRU is a useful analytic concept. It is useful as a theory to understand the causes of inflation. It is useful as an empirical basis for predicting changes in the inflation rate. And it is useful as a general guideline for thinking about macroeconomic policy' (Stiglitz, 1997, p. 3). The focus pf this paper is not on the reliability or otherwise of estimates of the NAIRU, but rather to evaluate the theoretical foundation of the models from which the NAIRU has been derived. For if those models are on some relevant criteria judged to be unsound, then estimates and policy conclusion derived are seemly unsound.