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The Natural Rate of Unemployment, Revisited

Recall the concept of the natural rate of unemployment, the portion of the unemploy-
ment rate unaffected by the swings of the business cycle. Now we have introduced the
concept of the NAIRU. How do these two concepts relate to each other?
The answer is that the NAIRU is another name for the natural rate. The level of un-
employment the economy “needs” in order to avoid accelerating inflation is equal to
the natural rate of unemployment.
In fact, economists estimate the natural rate of unemployment by looking
for evidence about the NAIRU from the behavior of the inflation rate and the
unemployment rate over the course of the business cycle. For example, the
way major European countries learned, to their dismay, that their natural rates
of unemployment were 9% or more was through unpleasant experience. In the
late 1980s, and again in the late 1990s, European inflation began to accelerate
as European unemployment rates, which had been above 9%, began to fall, ap-
proaching 8%.

fyi

The Great Disinflation of the 1980s
As we’ve mentioned several times, the United flation trends than the overall CPI. By this meas- Our analysis of the Phillips curve tells
States ended the 1970s with a high rate of in- ure, inflation fell from about 12% at the end of us that a temporary rise in unemployment,
flation, at least by its own peacetime historical the 1970s to about 4% by the mid - 1980s. like that of the 1980s, is needed to break
standards—13% in 1980. Part of this inflation How was this disinflation achieved? At the cycle of inflationary expectations. Once
was the result of one -time events, especially a great cost. Beginning in late 1979, the Federal expectations of inflation are reduced, the
world oil crisis. But expectations of future infla- Reserve imposed strongly contractionary economy can return to the natural rate of
tion at 10% or more per year appeared to be monetary policies, which pushed the economy unemployment at a lower inflation rate. And
firmly embedded in the economy. into its worst recession since the Great that’s just what happened.
By the mid-1980s, however, inflation was Depression. Panel (b) shows the Congressional At what cost? If you add up the output
running at about 4% per year. Panel (a) of the Budget Office estimate of the U.S. output gap gaps over 1980–1987, you find that the
figure shows the annual rate of change in the from 1979 to 1989: by 1982, actual output economy sacrificed approximately 18% of an
“core” consumer price index (CPI)—also called was 7% below potential output, corresponding average year’s output over the period. If we
the core inflation rate. This index, which ex- to an unemployment rate of more than 9%. had to do the same thing today, that would
cludes volatile energy and food prices, is widely Aggregate output didn’t get back to potential mean giving up roughly $2.6 trillion worth of
regarded as a better indicator of underlying in- output until 1987. goods and services.

(a) The Core Inflation Rate in the United States (b) . . . but Only at the Expense of a Huge
Came Down in the 1980s . . . Sacrifice of Output and High Unemployment.
Core Output gap
inflation (percent of
rate potential
14% output)
12 2%
10 0
8
–2
6
–4
4
2 –6
–8
1979 1981 1983 1985 1987 1989 1979 1981 1983 1985 1987 1989

Year Year

module 34 Inflation and Unemployment: The Phillips Curve 337