Non-accelerating Inflation Rate of Unemployment (NAIRU)
The Non-Accelerating Inflation Rate of Unemployment, often referred to as NAIRU or NARU, is the level of unemployment at which the inflation rate remains stable. It was introduced by Lucas Papademos and Franco Modigliani in the early 1970s. The NAIRU theory requires central banks to allow or tolerate a certain level of unemployment to avoid inflation from accelerating.
When the concept was first introduced, NARU was an acronym for natural rate of unemployment. Some unemployment was considered necessary or ‘natural’. Of course, the idea that an economy should tolerate a certain amount of unemployment is quite controversial. As a consequence, economists have tended to avoid the use of ‘natural’ and have replaced it with ‘non-accelerating’.
The NAIRU explained
Taking a closer look at the term Non-accelerating rate of unemployment, we notice that the NAIRU focuses on ‘non-accelerating inflation’. Thus, it does not mean that there is no inflation at the NAIRU level of unemployment. Instead, the inflation rate is stable, for example 2% inflation per year. In such an economic environment, prices only increase gradually at this level of inflation. But what happens when unemployment is lower than this rate?
In that case, the inflation rate accelerates. This does not mean that the level of inflation rate increases just once from 2% to 3%. On the contrary, inflation that is accelerating means, the longer the economy stays at a level of unemployment below the NAIRU, the higher the inflation rate will become. Thus, inflation may initially go up from 2% to 3%. If the central bank insists on keeping unemployment too low, it may then go up to 4% etc. Thus, we do not move to a higher level of inflation, not the inflation rate itself increases.
NAIRU and the Phillips curve
The concept of NAIRU was introduced around the same period that the Phillips curve was first proposed. The Phillips curve nicely fitted the NAIRU concept. In particular, the Phillips curve summarized an observed negative relationship between the inflation rate and the level of unemployment for a large set of developed economies. After its discovery, however, the relationship has considerably weakened. Nevertheless, the Phillips curve suggested a trade-off between unemployment and inflation consistent with the NAIRU.
The NAIRU has been criticised considerably. First, the Phillips curve, which provided considerable empirical support for the NAIRU concept, has proven to be quite unstable. In fact, today the trade-off between unemployment and inflation seems to be largely absent. Thus, the NAIRU may be time-varying. Second, the existence of hysteresis implies if unemployment remains high for a considerable period of time, the NAIRU may increase as well. This too suggest that the ‘natural rate’ is not a fixed number.
We discussed the non-accelerating rate of unemployment. This theory argues that there is a trade-off between inflation and unemployment. If unemployment drops below this natural rate, inflation starts to accelerate. The only way to stop this vicious circle, is to let unemployment increase again.