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Rethinking the role of NAIRU in monetary policy: implications of model formulation and uncertainty

  • Arturo Estrella
  • Frederic Mishkin

In this paper we rethink the NAIRU concept and examine whether it might have a useful role in monetary policy. We argue that it can, but success depends critically on defining NAIRU as a short-run concept and distinguishing it from a long-run concept like the natural rate of unemployment. We examine what effect uncertainty has on the use of NAIRU in policy. Uncertainty about the level of NAIRU does not imply that monetary policy should react less to the NAIRU gap. However, uncertainty about the effect of the NAIRU gap on inflation does require adjustments to the policy reaction function. Also, as in Brainard (1967), uncertainty about the effect of the monetary policy instrument on the NAIRU gap reduces the magnitude of the policy response. We estimate a simple NAIRU gap model for the United States to obtain quantitative measures of uncertainty and to assess how these measures affect our view of the policy reaction function.

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Paper provided by Federal Reserve Bank of New York in its series Research Paper with number 9806.

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Date of creation: 1998
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Handle: RePEc:fip:fednrp:9806
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  1. Christina D. Romer & David H. Romer, 1997. "Reducing Inflation: Motivation and Strategy," NBER Books, National Bureau of Economic Research, Inc, number rome97-1, December.
  2. Svensson, Lars E O, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," CEPR Discussion Papers 1511, C.E.P.R. Discussion Papers.
  3. Douglas Staiger & James H. Stock & Mark W. Watson, 1997. "The NAIRU, Unemployment and Monetary Policy," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 33-49, Winter.
  4. Fuhrer, Jeffrey C & Moore, George R, 1995. "Monetary Policy Trade-offs and the Correlation between Nominal Interest Rates and Real Output," American Economic Review, American Economic Association, vol. 85(1), pages 219-39, March.
  5. Newey, Whitney & West, Kenneth, 2014. "A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix," Applied Econometrics, Publishing House "SINERGIA PRESS", vol. 33(1), pages 125-132.
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  7. Wieland, Volker, 2003. "Monetary Policy and Uncertainty about the Natural Unemployment Rate," CEPR Discussion Papers 3811, C.E.P.R. Discussion Papers.
  8. Franco Modigliani & Lucas Papademos, 1975. "Targets for Monetary Policy in the Coming Year," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 6(1), pages 141-166.
  9. Robert J. Gordon, 1996. "The Time-Varying NAIRU and its Implications for Economic Policy," NBER Working Papers 5735, National Bureau of Economic Research, Inc.
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  12. Layard, Richard & Bean, Charles, 1989. " Why Does Unemployment Persist?," Scandinavian Journal of Economics, Wiley Blackwell, vol. 91(2), pages 371-96.
  13. Douglas Staiger & James H. Stock & Mark W. Watson, 1996. "How Precise are Estimates of the Natural Rate of Unemployment?," NBER Working Papers 5477, National Bureau of Economic Research, Inc.
  14. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Working Papers in Applied Economic Theory 98-03, Federal Reserve Bank of San Francisco.
  15. Marco A. Espinosa-Vega & Steven Russell, 1997. "History and theory of the NAIRU: a critical review," Economic Review, Federal Reserve Bank of Atlanta, issue Q 2, pages 4-25.
  16. Joseph Stiglitz, 1997. "Reflections on the Natural Rate Hypothesis," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 3-10, Winter.
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