The European Commission’s new NAIRU: Does it deliver?

Abstract

The non-accelerating inflation rate of unemployment (NAIRU) is a key component of potential output and as such critically affects output gap estimates. In May 2014, the European Commission changed its specification of the NAIRU for several countries and lowered its NAIRU estimates – in the case of Spain from 26.6% to 20.7% for 2015. To test the dependence of the new NAIRU on unemployment versus structural factors, we run counterfactual simulations applying 1SD shocks to actual unemployment and to the structural variable – real unit labour costs. We find that the NAIRU in its new specification is still largely determined by actual unemployment. This calls in question both the interpretation of potential output estimates as barriers to more vigorous inflation-stable economic activity and the accuracy of structural deficit figures.

Keywords:

• NAIRU
• Kalman filter
• output gap
• euro area

JEL Classification:

• E23
• E24
• E31

Notes

¹ The EC uses the term NAWRU (non-accelerating wage rate of unemployment), the W instead of the I indicating that the wage inflation rather than the price inflation features in the Phillips curve. Throughout the text we use the terms interchangeably.

² Testing the robustness of this choice, the effects turned out to be only weakly nonlinear with respect to the sign of the shock, with slightly more pronounced effects for both shocks in the case of the simulations shown.

³ The closing rule implies that the projection of actual unemployment adjusts to the NAIRU, which is supposed to follow an almost flat path in the medium term projection (Havik et al. 2014).