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NAIRU: Do we really know the full employment level?

Paul Krugman is one of my favorite economists. He has a natural talent to make his brilliant insights in economics understandable for just about anyone. This morning, Krugman posted a short article on New York Times’ Opinion Page about his take on the currently falling unemployment rate which I know many of you have been discussing on their posts.

As we have learned in class, Phillips Curve demonstrates a negative relationship between unemployment rate and price change. Currently, the unemployment rate fell to 5.5 percent, achieving the lowest level since May 2008. However, Krugman points out that we have not yet observed an acceleration in inflation, while unemployment rate has been falling. Krugman suspects that we now may have a new lower bound on NAIRU.

If this is the case, Krugman assures that it will not the first time economists did not know where NAIRU is. In 1994, NAIRU was widely assumed to be about 6%. However, Fed was determined to find the actual number and waited to observe the evidence of rising inflation. It turned out that a long run of job growth brought down the unemployment rate below 4 percent without any kind of inflationary explosion.

Krugman writes, it is possible that “full employment really is 5.3 percent unemployment, and by the time…the inflation rate will have ticked up a bit above the Fed’s target”. He warns us of the cost associated with our failure to pinpoint the actual NAIRU range: the liquidity trap.

One Comment

  1. NAIRU is a conceptual construct, and while there are economists who believe there is some stable number, the empirical evidence does not support that. So instead the Fed needs to watch an array of indicators for inflation. It remains a judgement call: if higher interest rates take 6 months to start having an effect and 12 months (or more) to have their full effect, then you probably don’t want to wait a year after the first signs of inflation, just to be sure.

    it matters very much though whether you treat 2% as a target or as a “hard” ceiling. That is in part a matter of personal preferences (inflation above jobs) and in a part a judgement that it’s easier to slow inflation than to increase jobs (and again that’s only a tradeoff if you believe jobs ought to matter). In the latter case, it’s better to overshoot inflation than to raise interest rates too soon and undershoot employment, or worse both employment and inflation.

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