History and theory of the NAIRU: a critical review

Economic commentators regularly urge the Fed to use the level of unemployment or the rate of change in wages as leading indicators of inflation and as guides to whether they should ease or tighten monetary policy. The logic behind this approach is based on modern (post-1970) Keynesian macroeconomics and, more specifically, on the Phillips curve and the nonaccelerating inflation rate of unemployment (NAIRU). This article attempts to provide some basic information about this NAIRU theory of the causes of inflation and the role of monetary policy. After describing the historical development of the NAIRU theory, the discussion raises some practical questions about the validity of the theory and its usefulness as the basis for policy advice. Perhaps the most important question involves the difficulty of distinguishing policy-induced changes in nominal wages that reflect future changes in the price level from changes in relative wages associated with real changes in the economy. The authors also describe recent developments in neoclassical theory that indicate that business cycle fluctuations in employment and output may be caused primarily by real forces-a situation that, if true, increases the danger that monetary policy based on the NAIRU may interfere with the proper functioning of the price system.