New study: Estimating the NAIRU for Israel, 1992–2011

Estimating the NAIRU for Israel 1992–2011.docThis press release as a Word document

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The Non-Accelerating Inflation Rate of Unemployment ("NAIRU") is an important variable in managing monetary policy.  It is an unobserved variable (which changes over time as a result of various factors), the estimation of which is important both in estimating inflationary pressure and in evaluating developments in the labor market.

For instance, a decline of the observed unemployment rate below the NAIRU can be interpreted as the result of excess demand which could create inflationary pressures. However, the same is not true if the decline in the unemployment rate reflects a decline in the NAIRU.

A new study carried out by Mr. David Elkayam and Dr. Alex Ilek of the Bank of Israel Research Department presents an updated estimate of the NAIRU for the Israeli economy between 1992 and 2011, by estimating the negative correlation between the inflation rate and the gap between the actual unemployment rate and the NAIRU. In the period between 2004 and 2011, Israel's unemployment rate declined substantially, by 6.5 percentage points, without any significant inflationary pressure (excluding the effects of other factors that impact inflation, such as changes in the real exchange rate). A central finding of the study is that the decline in the unemployment rate during this period reflects mainly a decline in the NAIRU (a decline of about 5.5 percentage points). This is almost certainly against the background of the policy adopted since 2002 to encourage employment.

One of the ways to identify the NAIRU is through the Kalman filter while exploiting the relationship between the NAIRU and a number of observed variables such as inflation and the actual unemployment rate. The study's assumption is that the economy is characterized by a neo-Keynesian Phillips Curve showing that the actual inflation rate is affected by the expected inflation rate (which is also an unobserved variable), by the gap between the NAIRU and the actual unemployment rate, and by changes in the real exchange rate. The findings indicate that the main changes that took place in the unemployment trend during the estimation period resulted from changes in the NAIRU. In particular, out of the 6.5 percentage point decline in the unemployment rate between 2004 and 2011, 5.5 percentage points are attributed to a decline in the NAIRU. It was also found that the estimated NAIRU helps in identifying the negative correlation between the job vacancy rate and the unemployment rate, which is reflected in the Beveridge curve.

The findings show that a decline of one percentage point in the unemployment rate, compared to the NAIRU, operates with a lag of one quarter to temporarily increase inflation by 0.3 percent, and an increase of 0.25 percent with a delay of one year.