Can the US economy grow more than 2.5% per year and the unemployment rate fall below 5% without causing an increase in inflation ? This question has become a hotly debated issue in the US today. A number of mainstream economists (for example Paul Krugman) have arguing that the long-run potential growth rate of the US economy is about 2.5% per year and that the natural rate of unemployment is in the 5.5-6.0% range. If unemployment would fall below its natural rae and output grow above its long-term potential rate, inflation would start to increase as bottlenecks in production, capacity limits and tight labor market would lead workers to require higher wages and firms to increase price as demand and costs go up. While most participants to the debate agree that inflation might eventually increase if the economy grows above its potential rate, there is a very broad discussion on whether the potential growth rate of the economy is around 2.5% and whether the Non Accelerating Inflation Rate of Unemployment (NAIRU) is around 5.5%. On this issue, opinions widely diverge: in fact, there is no way to exactly estimate the value of NAIRU as the natural rate of unemployment is not constant but changes over time depending on the factors that determine the structural uenmployment rate of the economy.
A related issue is the question of whether "inflation is dead" as argued by some authors or whether inflation will soon start to increase as we are getting close to the NAIRU zone. So far, inflation has remained stable in the 3.0% range ins spite of the fact that the unemployment rate has been below 5.5% since 1995. Is this just luck ? Is is due to favorable supply shocks ? Is it due to structural changes in labor and goods markets (such as a weakening of unions' power, very competitive pricing conditions, the openness of the U.S. economy to world trade and competition) that have reduced permanently the long-term inflation rate in the economy ?
To understand the current policy controversy on the NAIRU (Non-Accelerating Inflation Rate of Unemployment) and inflation, we have first to review a few macroeconomic concepts. The first one is the Phillips Curve or the relation between the inflation rate and the unemployment rate: this relation suggests that when the unemployment rate is low inflation tends to increase while when the unemployment rate is high inflation tends to decrease. More specifically, this curve posits that the inflation rate depends on three factors:
1. The expected inflation rate (pte) in year t.
2. The deviation of the unemployment rate (Ut ) in year t from the natural unemployment rate ( Utn).
3. A supply shock (x).
pt = pte - a (Ut - Utn) + x
where the inflation rate (pt) is the yearly rate of change of the price level (the % rate of change of the CPI or GDP deflator between year t and year t-1):
pt = (Pt - Pt-1 )/ Pt-1
(Utn) is the natural rate of unemployment determined by structural long-term factors that determine how many workers will be unemploymed even the the economy is running at full capacity and close to its long-run potential growth rate.
If, as appears to be the case in the United States today, the expected rate of inflation (pte) is well approximated by last year's inflation rate (t-1), the relation becomes:
pt = pt-1 - a (Ut - Utn) + x
This relation links the the difference between te actual rate of unemployment and the natural rate of unemployment to the change in inflation. When the actual unemployment rate exceeds its natural rate, inflation decreases; when the actual unemployment rate is less than the natural rate, inflation increases. So, the natural rate of unemployment can be seen as te rate of unemployment required to keep inflation constant. This is why the natural rate of unempoyment is also called the Non-Accelerating Inflation Rate of Unemployment or NAIRU. Note that the natural rate and its changes over time are hard to measure since we observe only the actual uemployment rate. There is a debate currnetly raging in the U.S. about what is the natural rate or the NAIRU. Usually the level and the broad changes in the natural rate can be measured by comparing average unemployment rates in various decades. The average unemployment rate was 4.4% in the 1960s, 6.2% in the 1970s, 7.2% in the 1980s and 6.2% in the 1990s. If we believe that the natural rate is equal to the average unemployment rate in the decade, the current 5.2% unemployment rate is below the natural rate of 6.2%. Most mainstream economists believe that the natural rate is closer to 5.5% as the actual unemployment rate was high during the 1990-91 recession. Even if the natural rate is 5.5%, we get a puzzle: according to the NAIRU curve, the inflation rate should have been increasing since the late part of 1995 when the unemployment rate fell below the 5.5% level. Instead there is no evidence that the inflation rate is accelarating these days. What can explain this contradiction. There are very different alternative explanations:
1. According to some, there are structural changes in the economy that have led to a reduction of the NAIRU to a level closer to 5% or even below that.
2. According to others, we are already below the natual rate now and inflation will start to increase soon. Accoding to this interpretation we have not seen the increase in inflation yet only because there were a series of favorable exogenous shocks that have maintained the inflation rate low so far. A recent Wall Street Journal article presents this viewpoint about favorable supply shocks. But inflation will start to increase soon unless the economy growth rate slows down and the unemployment goes back above the 5.5% level.
A mainstream view of why the economy cannot grow faster
than its current 2.5% rate and why we are already close to the NAIRU is
given by Paul
Krugman in his article "Stable prices and fast growth: just say no".
A few recent articles that take different views include:
Rosett, "Greenspan's dilemma" The Wall Street Journal, Dec 15, 1997.
Angell, "Fed: on the right course" The Wall Street Journal, Dec 16, 1997.
Mankiw "Alan Greenspan's tradeoff" Fortune, Dec 8, 1997; in RP.
The Fed's Chairman (Greenspan) view on the current U.S. macro outlook and on NAIRU are presented in a speech he gave in December 1996, a more recent speech in September 1997 and his recent testimony in Congress.
For two contrarian views arguing that the economy can grow faster than current rates without a resurgence of inflation and that NAIRU is lower than the present unemployment rate see an article by Robert Eisner and an article by Lester Thurow.
For a Wall Street view on the risk of resurging inflation see the comments of Stephen Roach, chief economist at Morgan Stanley and leading proponent of the view that the inflation rate will increase in 1997-98.
For a middle of the road mainstream view of NAIRU, see
by James Tobin, a Yale University economist and Nobel prize winner.