Estimating the NAIRU

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Estimating the NAIRU

• A Case Study in Economic Policy
• EC134 Macroeconomic Principles

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Potential Output theNon Accelerating Inflation
Rate of Unemployment
P
LRAS
SRAS(Pe)
P
AD(PG,T,Ms)
Y
Y
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Analytical Framework

• Construct a Phillips Curve equation from which we
  can estimate the NAIRU for the United States.
• If we know the NAIRU, we can make inferences
  about the appropriate direction of fiscal and
  monetary policy.

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Phillips Curve 1
w a0 pe a1UR a2PROD
w wage inflation pe expected inflation UR
unemployment rate PROD productivity growth
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Define a Mark-up Equation

• Assume that the rate of price inflation is
  determined by the rate of change in unit labor
  costs and other supply-side factors.
• These factors can take the form of import price
  shocks and wage price controls.

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Unit Labor Costs

• Define unit labor costs as the difference between
  wage inflation and the growth in labor
  productivity.
• Intuition high productivity growth implies lower
  per unit costs of labor.

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Mark-up Equation

• p w PROD S
• p price inflation
• w wage inflation
• PROD rate of growth of labor productivity
• S supply-side factors

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Some Algebra

• Redefine the mark-up equation in terms of wage
  inflation.
• Then substitute that into the wage-price Phillips
  Curve.
• To produce a price-price Phillips Curve that can
  be estimated econometrically.

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Phillips Curve 2

• p a0 pe a1UR b1PROD b2S e
• Hypotheses
• a1 lt 0 Unemployment/Inflation tradeoff.
• b1 lt 0 Productivity-enhancing technical change
  lowers structural inflation.
• Supply shocks correspond to upward adjustments to
  SRAS.

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Long-run

• No supply shocks.
• There is some trend rate of growth for labor
  productivity.
• p pe, i.e., inflationary expectations are borne
  out.
• Long-run Phillips Curve is inelastic.

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Solving for NAIRU

• Steady-stating this equation means setting p
  pe and solving our price-price Phillips Curve
  equation for the long-run value of UR.
• UR (a0 b1PROD) / -a1

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Estimation Issues

• Sample period.
• Measuring inflation.
• Measuring labor productivity.
• Identifying supply-side phenomena.
• Modeling expectations.

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Sample Period Issues

• Structural changes to the economy alter the trend
  rate of growth of productivity.
• Most recent productivity enhancements have
  occurred too recently to provide enough
  historical experience to produce reliable
  estimates.
• Use as much historical data as possible.

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Measuring Inflation

• PCE price index
• 2000 100
• Broad measure of consumer price inflation

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Measuring Productivity

• BLS has made recent efforts to improve
  productivity estimates.
• Service sector productivity very difficult
  conceptually and from a practical standpoint.
• Use total non-farm business sector.
• An index 1992 100.

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Supply-Side Effects

• President Nixons wage price controls.
• Oil price shocks.
• Import price inflation less core CPI inflation.
• Assume all are equal to zero in the long-run.

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Expected Inflation

• Assume a simple, adaptive expectations model.
• Weighted average of past inflation rates.
• People predict inflation based on past
  experience.

Weights (gi) sum to 1.02.
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Econometric Results
p 2.105 1.0pe 0.035PROD 0.079(pm- pc)
1.366NIXON 0.279NIXOFF 0.350UR

• Check interpretation of coefficients
• Check statistical significance
• Calculate implied NAIRU estimates

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NAIRU Estimate

• Depends on your assumption about the trend rate
  of growth of labor productivity.
• Use CEA 2004 ERP forecast of 2.1
• NAIRU 5.8