The Macroeconomics of Low Inflation

THE CONCEPT of a natural unemployment rate has been central to most modern models of inflation and stabilization. According to these models, inflation will accelerate or decelerate depending on whether unemployment is below or above the natural rate, while any existing rate of inflation will continue if unemployment is at the natural rate. The natural rate is thus the minimum, and only, sustainable rate of unemployment, but the inflation rate is left as a choice variable for policymakers. Since complete price stability has attractive features, many economists and policymakers who accept the natural rate hypothesis believe that central banks should target zero inflation. We question the standard version of the natural rate model and each of these implications. Central to our analysis is the effect of downward nominal wage rigidity in an economy in which individual firms experience stochastic shocks in the demand for their output. We embed these features in a model that otherwise resembles a standard natural rate model and show there is no unique natural unemployment rate. Rather, the rate of unemployment that is consistent with steady inflation