by As yours truly argued in a post the other day, NAIRU does not hold water simply because it hasn’t existed for the last 50 years. But still today ‘New Keynesian’ (a monstrous misnomer) macroeconomists use it — and its cousin the Phillips curve — as a fundamental building block in their models. Why? Because without it ‘New Keynesians’ have to give up their (again and again empirically falsified) neoclassical view of the long-run neutrality of money and the simplistic idea of inflation as an excess-demand phenomenon. The NAIRU approach is not only of theoretical interest. Far from it. The real damage done is that policymakers that take decisions based on NAIRU models systematically implement austerity measures and kill off economic expansion. The unnecessary and costly unemployment that this self-inflicted and flawed illusion eventuates, is something its New Classical and ‘New Keynesian’ advocates should always be kept accountable for! According to the [NAIRU theory], unemployment differs from its natural rate only if expected inflation differs from actual inflation. If expectations are rational, we should see as many quarters when inflation is above expected inflation as quarters when it is below expected inflation. That suggests the following test of the [NAIRU theory]..
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As yours truly argued in a post the other day, NAIRU does not hold water simply because it hasn’t existed for the last 50 years. But still today ‘New Keynesian’ (a monstrous misnomer) macroeconomists use it — and its cousin the Phillips curve — as a fundamental building block in their models. Why? Because without it ‘New Keynesians’ have to give up their (again and again empirically falsified) neoclassical view of the long-run neutrality of money and the simplistic idea of inflation as an excess-demand phenomenon.
The NAIRU approach is not only of theoretical interest. Far from it.
The real damage done is that policymakers that take decisions based on NAIRU models systematically implement austerity measures and kill off economic expansion. The unnecessary and costly unemployment that this self-inflicted and flawed illusion eventuates, is something its New Classical and ‘New Keynesian’ advocates should always be kept accountable for!
According to the [NAIRU theory], unemployment differs from its natural rate only if expected inflation differs from actual inflation. If expectations are rational, we should see as many quarters when inflation is above expected inflation as quarters when it is below expected inflation. That suggests the following test of the [NAIRU theory]..
Because a decade contains 40 quarters, the probability that average expected inflation over a decade will be different from naverage actual inflation should be small. If the [NAIRU theory] and rational expectations are both true simultaneously, a plot of decade averages of inflation against unemployment should reveal a vertical line at the natural rate of unemployment … This prediction fails dramatically.
There is no tendency for the points to lie around a vertical line and, if anything, the long-run Phillips is upward sloping, and closer to being horizontal than vertical. Since it is unlikely that expectations are systematically biased over decades, I conclude that the [NAIRU theory] is false.
Defenders of the [NAIRU theory] might choose to respond to these empirical findings by arguing that the natural rate of unemployment is time varying. But I am unaware of any theory which provides us, in advance, with an explanation of how the natural rate of unemployment varies over time. In the absence of such a theory the [NAIRU theory] has no predictive content. A theory like this, which cannot be falsified by any set of observations, is closer to religion than science.
For more NAIRU critique see Merijn Knibbe’s post on the rwer blog today.