Question

Consider the statement …This suggests that, in our newly stagnant world, the true NAIRU is a lot lower: 4.5 per cent, maybe 4 per cent… Using the static AD-AS model, discuss what might happen if the government incorrectly assumes the NAIRU is still 5 percent when it really is 4 percent and stimulates demand to reduce unemployment.

Answer 1

The non-accelerating inflation rate of unemployment (NAIRU) is the specific level of unemployment that is evident in an economy that does not cause inflation to increase. In other words, if unemployment is at the NAIRU level, inflation is constant. NAIRU often represents the equilibrium between the state of the economy and the labor market.

Suppose that the unemployment rate is at 5% and the inflation rate is 2%. Assuming that both of these values remain the same for a period, it can then be said that when unemployment is under 5%, it is natural for an inflation rate of 2% to correspond with it. Critics cite that it is unlikely to have a static rate of unemployment that lasts for long periods of time because different levels of factors affecting the workforce and employers (such as the presence of unions and monopolies) can quickly shift this equilibrium.

Unemployment is unpleasant, but because looking for jobs and looking to fill jobs can't happen instantaneously, there is always going to be some. The bigger question is if it's really true that getting joblessness down to 4.5 percent and holding it there would create run-amok inflation. Imagine that instead of a wage-price spiral, we see something like this: because workers are scarce, employers need to raise pay to keep and retain workers. Some of those additional costs are passed through in the form of higher prices.