The role of expectations in estimates of the NAIRU in the United States and the United Kingdom

During the second half of the 1990s the US economy was characterised as the Goldilocks economy: not too hot, nor too cold, but just right. It was argued that this represented a new paradigm, enabling unemployment to remain low without igniting inflationary pressure. In this paper the evidence for a change in the relationship between inflation and unemployment is examined and the US experience compared with that of the United Kingdom within a common analytical framework. To that end, Phillips-curve models are employed based on estimates of time-varying NAIRUs, obtained using the Kalman filter. The impact of including explicit inflation expectations is also considered. This channel has not been explored in previous work based on Kalman filter estimates of the NAIRU for the United States and United Kingdom. Inflation expectations are found to play a particularly important role in the United States. When expectations are included there is still evidence that the NAIRU steadily declined during the late 1990s, although this decline in the US NAIRU is not found solely in the 1990s.