Economics Update (April-June 1997)

Link Between Unemployment and
Inflation is Uncertain

F rom a variety of perspectives, the macroeconomic performance of the U.S. economy has been very satisfactory in recent years. In particular, broad-based measures of inflation have stabilized between 2 1/2 and 3 percent while unemployment has fallen below 5 1/2 percent. However, many observers remain uneasy, believing that the current situation is fragile and temporary. This belief is, in turn, rooted in a less obvious view that the current rate of unemployment is "too low" to be consistent with low and stable inflation.

Isn't low unemployment good for the country? And why is low unemployment supposed to lead to higher inflation anyway? These are important and difficult questions. Roberto Chang, a research officer in the macropolicy section of the Atlanta Fed's research department, explores these issues in a recent article in the Atlanta Fed's Economic Review.

Chang focuses on an influential economic theory that implies that unemployment is unambiguously "good" only up to a point. If unemployment falls below this point, known as the nonaccelerating inflation rate of unemployment (NAIRU), inflation tends to accelerate. Opinions about the current location of the NAIRU vary, but many published estimates place it close to 6 percent. Since recent unemployment figures have been consistently below that range, adherents to this theory predict that inflation will accelerate.

So far these predictions have turned out to be wrong. Their failure should not be a surprise, according to Chang, because the concept of the NAIRU is of very limited use for predicting inflation, understanding its causes or forming policy.

Chang presents both empirical and theoretical support for his view. On the empirical side, Chang discusses evidence showing that the NAIRU moves around and that there is a great deal of uncertainty about where it is at any particular time. These findings imply that, in practice, one cannot know if unemployment is above or below the value supposedly consistent with stable inflation.

On the theoretical side, Chang argues that even if such a value became known, it would be irrelevant for predicting inflation. Contemporary economic theory implies that movements of the unemployment rate may be positively or negatively related to inflation, depending on the nature of the fundamental shocks causing the unemployment changes. Identifying such shocks is possible and helpful for predicting the inflation implications of unemployment changes; but to the extent that these shocks can be identified, knowing whether current unemployment is above or below the NAIRU provides no additional useful information about prospective changes in inflation.

The arguments Chang discusses highlight the need to further develop models in which the fundamental forces behind macroeconomic fluctuations can be identified and analyzed. Fortunately, he concludes, a body of outstanding research in that direction is already in progress.

Return to Index