The NAIRU in Canada: Concepts, Determinants and Estimates

An important question that faces macroeconomic policy makers is whether the economy can absorb increases in aggregate demand without generating inflationary pressures. Many economists have found it useful to approach this issue by asking whether the economy is operating at a rate of unemployment consistent with inflation neither accelerating nor decelerating, all else being equal. This rate is widely referred to as the NAIRU, an acronym from non-accelerating-inflation rate of unemployment.

This paper reviews the determinants of the NAIRU, why it may change over time, and various methodologies that have been used to measure it. The discussion of determinants considers: factors that influence the incentives to be in the labour force and to work (such as the effect of unemployment insurance); aspects of the composition of the labour force (such as age and gender); particular supply factors (such as the role of unions); and temporary structural influences in the economy (such as response to major relative price changes). The discussion of methodology covers: reduced-form unemployment equations; the Phillips curve (for price as well as wage inflation) and Okun's Law; and new work at the Bank of Canada that combines Okun's Law, a production function and the Phillips curve in a simultaneously estimated system.

Recent work in the Bank of Canada Research Department concerning the NAIRU is summarized, and estimates and methodologies are compared with those of other researchers. The point estimates range widely and, in general, are not statistically well determined. We show that the same uncertainty surrounds the point estimates presented by other researchers. Therefore, an element of judgment is required in drawing any conclusions from the empirical work. The judgement reached in this paper is that the NAIRU for Canada at the end of 1987 was about 8 per cent, and that there are factors working to reduce it over the medium term.