17 July 2013

New working paper on the NAIRU in Iceland and its determinants

Working paper no. 64, „How “natural” is the natural rate? Unemployment hysteresis in Iceland“, by Bjarni G. Einarsson and Jósef Sigurdsson has now been published. The paper estimates the NAIRU for Iceland and evaluates which factors influence its variations over time.

The paper estimates the Non-Accelerating Inflation Rate of Unemployment (the NAIRU) for Iceland based on the Phillips curve using an iterative regression process and the Kalman filter. According to the results, the NAIRU rose sharply in the wake of the financial crisis, peaking at 5½% or 7% depending on estimation methodology. The results indicate that the NAIRU was 5.2-5.6% at the end of last year, and projected to be 4.2% by 2015.

An evaluation of which factors influence changes in the NAIRU is performed. In particular the paper assesses if changes in the NAIRU have been influenced by structural changes or changes in actual unemployment and therefore aggregate demand, i.e. whether there is evidence of hysteresis in unemployment. The paper finds that time variation in the NAIRU is to a large extent due to hysteresis effects but to a lesser extent due to structural factors. This implies that monetary policy can have long-run effects on unemployment and its conduct is thus more complicated. Prudency in government’s conduct of fiscal policy and labour unions' and their counterparties' wage bargaining becomes more important in presence of hysteresis in unemployment as inflationary pressures must be countered with a rise in interest rates which can cause an increase in the NAIRU. Keeping inflation low becomes more important for the real economy in the presence of hysteresis in unemployment.

The paper is accessible at the bank‘s website: Working papers