2  Overview of the NAIRU

2.1  Conceptual issues

The traditional NAIRU view established by Friedman (1968) is that in the long-run the structural rate of unemployment is reached and hence there is no long-term trade-off between inflation and unemployment. However, in the short-term the “Phillips Curve” suggests that a trade-off between inflation and unemployment exists so that if the rate of unemployment falls below (rises above) the NAIRU, inflation will rise (fall) until the rate of unemployment returns to the NAIRU, and then inflation will stabilise at that permanently higher (lower) level. Supply shocks and inflation expectations are also commonly felt to be important determinants of inflation and the NAIRU may change over time depending on the structure of the economy and government policy.

Within this framework, the OECD define three different NAIRU concepts, which vary by the timeframe they cover (Richardson et al 2000). One definition is the short-term NAIRU. The short-term NAIRU is the rate of unemployment required to stabilise the inflation rate at its current level in the next period. The short-term concept is more volatile by definition as it requires a level of NAIRU that will provide an inflationary offset to any impact from short-term supply shocks, expectations, and possible speed limit/persistence effects (so could be affected by the level of actual employment).[3] Note that favourable short-term supply shocks may allow the unemployment rate to fall below our core NAIRU measure and disguise the inflationary impact, which may be New Zealand’s recent experience.

The second NAIRU definition applies to the medium-term concept. In this approach, the NAIRU is defined as the equilibrium rate which unemployment converges in the absence of temporary supply shocks and the dynamic adjustment of inflation to previous shocks is completed. This paper focuses on the medium-term NAIRU concept, which is here after simply referred to as the NAIRU.

The final definition is he long-term equilibrium unemployment rate which is equivalent to the long-term steady state, as the NAIRU has fully adjusted to all long and short-term supply and policy influences.

Of these three definitions the first two can be estimated, the short-term NAIRU can be directly estimated and the medium-term NAIRU can be estimated by controlling for appropriate short-term influences.[4] However, the long-term NAIRU tends to not get estimated in a Phillips curve framework due to difficulties in identifying the effects of individual long-lasting supply influences in a timely fashion. In New Zealand, this could be incorporating the long-run impact of the Employment Contracts Act on the labour market.

2.2  The New Zealand labour market

Since 1999 the New Zealand labour market has been characterised by a rapidly falling unemployment rate. The March 2004 seasonally adjusted unemployment rate of 4.3% is the lowest since December 1987 when it was 4.2%. The fall in New Zealand’s unemployment is due to particularly strong employment growth, which has more than offset a rising participation rate. Furthermore, inflationary pressures in the recent period have been milder than in previous periods when unemployment was this low. This observation could suggest that the New Zealand NAIRU has fallen. Many overseas studies have attempted to explain the movements in the NAIRU (see Gordon, 1996, Stiglitz, 1996 and Ball and Mankiw, 2002). The leading hypotheses include changes in demographics, changes in labour force, increases in competitiveness of labour and product markets, better job matching and higher productivity growth.

2.2.1  Possible structural determinants of the NAIRU

This section discusses some factors which could explain the movements of the New Zealand NAIRU over the 1988-2004 period. We begin in this section by first reviewing some key policy changes which could affect the competitiveness of the labour market. Then we turn our focus on the composition of the labour force.

Policy changes

Over the period 1988 to 2004 there were a number of policy changes which may have had a significant impact on unemployment and may help to explain changes in the NAIRU. One significant change is increased flexibility in wage bargaining as a result of the introduction of the Employment Contracts Act (ECA) in May 1991. Richardson et al., (2000) consider that the ECA could lower the NAIRU by up to ½% each year combined with the other structural labour market reforms.

Another substantial policy change is the benefit reforms introduced around the same time as the ECA. The reforms involved both reductions in basic benefits and a tightening in eligibility criteria. Maloney (1997) concludes that the 1990-91 benefit reforms substantially influenced labour market behaviour in New Zealand. He further suggests that 40 to 80% of the growth in employment between 1990 and 1995 can be attributed to the benefit reforms.

In addition, the Employment Relations Act (ERA) was introduced in October 2000, but there does not appear to be any evidence of it having a significant impact so far (Waldegrave, Anderson and Wong 2003).

Socio-demographic changes

The composition of the labour force can be an important determinant of the structural unemployment rate. For example, a hard to employ group (such as school leavers) becoming a more (less) significant part of the labour force is likely to raise (lower) the aggregate unemployment rate. Carroll and Chapple (2001) suggest that over the period 1985-2000 the change in the ethnic composition is likely to have increased the rate of unemployment. On the other hand, the age structure and education level of the population is likely to have decreased the rate of unemployment. They estimate that the changing composition of the labour force may have reduced the rate of unemployment by around 1%, with most of the socio-demographic benefits occurring between 1985 and 1992.