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The relationship between unemployment and inflation

What is NAIRU?

NAIRU is the acronym for Non-Accelerating Inflation Rate of Unemployment. It is the level of unemployment below which the rate of inflation is expected to rise. It means that, theoretically, the rate of inflation increases when the rate of unemployment goes below the NAIRU level. For example, if the actual unemployment rate is below the NAIRU level for several years, the inflation rate accelerates to match the rise in inflationary expectations.

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However, if the actual rate of unemployment is higher than the NAIRU level for a few years, inflationary expectations decrease, resulting in a decline in the rate of inflation. In the event that the actual rate of employment matches the NAIRU level, the rate of inflation will remain constant.

When the Federal Reserve is conducting monetary policy, the NAIRU level represents the lowest level to which the unemployment rate can fall before the rate of inflation starts to rise.


History of NAIRU

The concept of NAIRU arose from the concept of the Phillips Curve, which implies a negative correlation between the rate of inflation and the rate of unemployment in industrialized economies.

Thispsdrew[poi concept meant that it was impossible for the government to implement measures that focused on reducing unemployment and the prices of goods at the same time. However, economists started doubting the Phillips Curve in the 1970s when the rate of inflation and the rate of unemployment rose at the same time in industrialized countries. The situation was contrary to the theory that the Phillips Curve presented.

Critics of the Phillips Curve argued that the concept showed little theoretical basis since it showed a correlation between a real economic variable and a nominal economic variable. Milton Friedman and Edmund Phelps, in their counter-analysis, stated that the government macroeconomic policy was driven by a low unemployment target and caused the expectations of inflation to change. As a result, the rate of inflation accelerated gradually.


The Concept of Natural Rate of Unemployment

The natural rate concept was presented by Milton Friedman. In criticizing the Phillips Curve, Friedman argued that any given labor market structure faces some form of unemployment. Unemployment may be frictional or classical.

Frictional unemployment exists in any economy when people are changing jobs, or moving from one company to another, while classical unemployment occurs when the minimum wage an employee is willing to accept is in excess of what an employer is willing to pay. It may be caused by minimum wage laws or trade union requirements on the appropriate worker compensation. The rates of unemployment can only fall below the natural rate when the rates of inflation increase continuously.

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How to Calculate NAIRU

There are no specific methods of directly quantifying NAIRU, but it can be indirectly estimated using various statistical methods. We consider two main institutions that are involved in creating macroeconomic policies – they include the Congressional Budget Office (CBO) and the Federal Reserve.


The Congressional Budget Office (CBO)

The CBO calculates NAIRU by taking into account the historical relationship between the rate of unemployment and changes in the inflationary rate. It then uses the metrics to determine how future changes in the unemployment rate will affect the rate of inflation. The CBO also considers factors such as age and educational levels of the population to make the NAIRU estimates more reliable.


The Federal Reserve

The other institution that estimates NAIRU levels is the Federal Reserve. The members of the Fed’s Board of Governors and the Fed’s regional presidents contribute to arriving at the NAIRU estimate. Currently, the Fed sets the NAIRU level between 5% to 6%. The Fed’s objective of estimating the NAIRU is part of its dual mandate which includes ensuring price stability and maximum employment levels.

Price instability through deflation or rapid inflation can significantly affect the stability of an economy. The Federal Reserve’s Federal Open Market Committee (FOMC) aims to maintain a consistent inflation rate of below 2%. Ensuring price stability creates a stable economic environment for conducting business and helps in maintaining maximum employment levels.

Since there are people quitting and starting new jobs or businesses, there can never be 100% employment. Rather, there will be some level of unemployment that needs to be kept on the lower side. The “natural” rate of unemployment is determined by factors that affect the mobility of the labor market of the specific country.


Criticism of NAIRU

Some economists criticize the reliability of NAIRU as a policy-making tool due to its wide margins of error. The NAIRU level is estimated based on the historical relationship between the rates of unemployment and the rate of inflation, and the metrics are known to vary over time, resulting in varied outcomes at any given time. For example, college graduates face different unemployment levels compared to the less educated population, which may bring varied results when estimating the NAIRU level.


Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful:

  • Cyclical Unemployment
  • Labor Market
  • Stagflation
  • Wage Drift

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