The Non Accelerating Inflation Rate of Unemployment is the level of unemployment at which inflationary pressures in the economy are stable. According to supply-side economists, unemployment cannot be held permanently below its natural level.

Some argue if actual unemployment falls below the natural rate (i.e. equilibrium unemployment) - there is upward pressure on wage inflation that then feeds into general price inflation.

Clearly changes in unemployment do have an effect on the risk of inflation. Consider this comment from the Bank of England.

"Developments in the labour market are a key determinant of domestically generated inflation." (UK Monetary Policy Committee minutes)

As unemployment falls towards the NAIRU, skill shortages exert upward pressure on wages and producer prices, until any further falls in unemployment lead to future higher inflation.

What Determines The Nairu?

The NAIRU can and does vary between countries and changes over time for any one particular economy.

The rate of unemployment at which inflation starts to accelerate is determined by the efficiency of the labour market and the relative strength of employers and employees in the wage bargaining process

The changing nature of the wage bargaining process

·        Strength of Trade Unions - Unions have become much less powerful in the UK over the last twenty years. This has tilted the balance of power towards employers and helped to keep "inflation-busting" pay claims in check

·        Centralisation / decentralisation of pay bargaining There has been a switch towards local and regional pay settlements that can take more account of local differences in labour demand and supply

·        Scale of involuntary structural unemployment in the economy - measures to reduce structural unemployment should help to reduce the NAIRU if effective. This is because they increase the available labour supply in the economy

Competitiveness of product markets - impact on producers and labour

·        When product markets are more competitive there is intensive pressure on firms to control costs. Wage increases might only be justified by improvements in productivity

"External-shock" effects on wage bargaining

The economy can be affected by external economic shocks that effect expected inflation.

·        The global economic crisis in 1998 has brought down expectations of inflation

·        The fall in international commodity prices has had a similar effect - causing a sharp fall in inflation in many countries across the world. Lower input costs cause an outward shift in short run aggregate supply in the economy and should help to increase the real volume of national output

Most economists believe that the natural rate of unemployment has fallen in the UK over the last decade. This means that the economy can sustain a lower rate of unemployment without triggering off a renewed burst of wage inflation. The evidence supports this positive view often improving trade-off between unemployment and wage/price inflation. By the summer of 2000, unemployment in the UK had fallen to just 3.8% of the labour force (using the claimant count measure) whilst retail price inflation had remained comfortably within the government's target (2.5%0 and wage inflation was under control.

Economists at the OECD have estimated the NAIRU for the leading industrialised countries. Their estimates for 1997 are shown in the chart below. The UK comes out favourably in this international comparison. Our estimated NAIRU is substantially below that of Germany and France - although some way above that for the United States and Japan. The Netherlands (another country to have introduced widespread labour market reforms over the last fifteen years) is also estimated to have a lower NAIRU than the UK.