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Australia’s NAIRU

NAIRU – non-accelerating inflation rate of unemployment – is part of the CIE A2 course and below is a look at how it might affect the Australian economy and explanation of the theory.

While the US economy appears to be in danger of slipping into a double-dip recession and sovereign debt risks casts a shadow over Europe, the Australian economy powers on. The reason for this is the country’s biggest resources boom in more than a century. Perhaps the challenge of managing Australia’s economic success will turn out to be more difficult than steering the economy through the financial crisis. If economic growth picks up to 4% in the coming years, which is above the annual average rate, this will lead to serious capacity constraints and the economy would be heading towards full employment. With unemployment very close to 5% which Treasury estimates is Australia’s NAIRU – non-accelerating inflation rate of unemployment – a measure used to gauge when labour shortages start to feed into wage and inflation pressures. This would then threaten the RBA’s target band for inflation (2-3%) and lead to higher interest rates which would hurt those sectors of the economy that haven’t been a part of the commodity boom from China.

Explaining the NAIRU
Bill Phillips (of Phillips Curve fame) discovered a stable relationship between the rate of inflation (of wages, to be precise) and unemployment in Britain from the 1850’s to 1960’s. Higher inflation, it seemed, went with lower unemployment. To economists and policymakers this presented a tempting trade-off: lower unemployment could be bought at the price of a bit more inflation. However, Milton Friedman and Edmund Phelps (who both later picked up Nobel prizes, partly for this work), pointed out that the trade-off was only temporary. In his version, Friedman coined the idea of the “natural” rate of unemployment – the rate that the economy would come up with if left to itself. Now economists are likelier to refer to the NAIRU (non-accelerating inflation rate of unemployment), the rate at which inflation remains constant. The theory is explained below:

Suppose that at first unemployment is at the NAIRU, u* in the graph below, and inflation is at p0. Policymakers want to reduce unemployment, so they loosen monetary policy: that stimulates spending, so that unemployment goes down, to u1. Inflation rises to p1, along the initial short-run Phillips curve, PC1. But that raises inflationary expectations, so that workers demand higher wage increases and real wages rise again. Firms shed labour, returning unemployment to u*, but with a higher inflation rate, p1. The new short-run trade-off is worse, with higher inflation for any level of unemployment (PC2). In the long run the Phillips curve is vertical (LRPC).

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