In the rapidly changing world of global economics, it is crucial to comprehend labour markets, particularly in developing countries. One key topic is the Non-Accelerating Inflation Rate of Unemployment (NAIRU), which helps economists understand the balance between inflation and unemployment. For Bangladesh, an economy that is experiencing significant growth and undergoing substantial demographic changes, we must ask: Is the country now at its NAIRU level?
This question examines the details of Bangladesh's economy and considers what it means to be at or near this critical unemployment level. Considering the nation's recent economic trends and labour market issues, a detailed analysis will reveal whether Bangladesh's unemployment rate aligns with the NAIRU and what this might mean for future policies. Therefore, thoroughly examining data and theories will offer valuable insights into this critical economic topic.
The non-accelerating inflation rate of unemployment (NAIRU), initially introduced by Franco Modigliani and Lucas Papademos (1975) as the non-inflationary rate of unemployment (NIRU), marked a significant advancement in economic theory. It was built upon Friedman's (1968) concept of the Natural Rate of Unemployment, providing a more nuanced understanding of the relationship between unemployment and inflation. NAIRU is the specific unemployment level evident in an economy that does not cause inflation to increase. In other words, inflation is constant if unemployment is at the NAIRU level. NAIRU often represents the equilibrium between the state of the economy and the labour market. With no formula to determine the NAIRU, the Federal Reserve has historically used statistical models to estimate the NAIRU level, placing it somewhere between 5.0 per cent and 6.0 per cent unemployment. However, the NAIRU has been trending downward in recent years, with the St. Louis Fed estimating it to be between 4.0 per cent and 5.0 per cent from 2005 to 2030.
Structural Unemployment, e.g., skills mismatch, frictional unemployment, and geographical immobility, determines the Natural Rate of Unemployment (NR). In contrast to the headline unemployment rate, the natural rate (NR) and the non-accelerating inflation rate of unemployment (NAIRU) display significant stability and are anticipated to converge at the same level over time. This predictability serves as a reassuring anchor amidst the economic cycle fluctuations. In the short term, however, NAIRU tends to be more volatile due to short-term factors such as wage inflation and fluctuations in wage expectations. This volatility is crucial to comprehend, as inflation expectations -- a central element of the NAIRU -- adjust slowly over time. This gradual change can contribute to the persistence of economic trends. For example, inflation expectations may not adapt immediately during a recession when unemployment increases. As a result, a rise in demand can lead to decreased unemployment without an immediate effect on inflation.
Although NR and the NAIRU may diverge in the short term, they ultimately converge in the long run. This convergence highlights the need for effective economic policies that foster stability in the labour market. Understanding this connection is crucial for policymakers in their quest to maintain a balanced and stable economy.
The Significance of NAIRU in Economic Analysis
NAIRU is essential for understanding the following economic dynamics:
• When the unemployment rate exceeds the NAIRU, the economy operates below its full employment potential, which creates downward pressure on inflation.
• When the unemployment rate falls below the NAIRU, the economy operates beyond its full capacity, resulting in upward pressure on inflation.
• Recognizing the concept of NAIRU is not enough. It is the application of this knowledge that enables policymakers to maintain a balanced and stable economy. Their decisions and actions, guided by the understanding of NAIRU, play a crucial role in shaping the economic landscape.
The Relationship Between Unemployment Rate and Inflation Rate (Phillips Curve)
In 1958, A. W. H. Phillips established an inverse relationship between unemployment and inflation rates, represented by the Phillips Curve.
Fluctuations in the money supply affect inflation. An increase in the money supply has a significant impact on the prices of goods and services in the economy, leading to a general rise in prices. Figure 1 illustrates both the short-run (which demonstrates the inverse relationship between inflation and unemployment in the immediate future) and the long-run (which shows the relationship over a more extended period, taking into account factors like expectations and wage adjustments) Phillips curves.
The NAIRU is closely linked to the short-run Phillips Curve, highlighting the inverse relationship between unemployment and inflation. When unemployment rises, inflation typically decreases, and conversely, when unemployment falls, inflation tends to increase. The short-run Phillips Curve is a valuable tool for understanding this dynamic.
However, this trade-off does not persist in the long run. This is because households and businesses anticipate that a lower unemployment rate will ultimately lead to higher inflation. Grasping this concept is crucial for understanding the long-run Phillips Curve.
In the long run, while monetary policy can influence temporary fluctuations in the unemployment rate around the NAIRU, it cannot easily alter the long-term unemployment rate. Nevertheless, policymakers can affect the long-term unemployment rate by implementing government policies that directly address the NAIRU, such as labour market regulations and social welfare programs.
Bangladesh Context
Bangladesh has experienced moderate inflation, primarily driven by food prices and supply-side factors, while maintaining relatively stable unemployment rates.
In 2023, the unemployment rate in Bangladesh was 5.06%, which posits that Bangladesh is at the NAIRU level (4%-5%) at present (according to the Federal Reserve), whereas the inflation rate in Bangladesh was 9.88%. In 1991, the unemployment rate in Bangladesh was 2.2%, while the inflation rate was 6.36%. The unemployment rates in Bangladesh from 2000 to 2002 (3.27%, 3.61%, and 3.97%, respectively) were more significant than the inflation rate (2.21%, 2.01%, and 3.33%, respectively). From 1991 to 2023, the correlation between the unemployment rate and the inflation rate in Bangladesh is tenuous (close to zero which indicates a weak relationship between these two variables.
Due to various macroeconomic pressures, determining whether Bangladesh's unemployment rate is at or near the NAIRU is difficult. Bangladesh faced high inflation in late 2023 and early 2024, averaging over 9% for much of 2023, driven by currency depreciation, high import costs, and supply chain disruptions. Additionally, the lack of precise and timely unemployment data complicates comparisons to NAIRU, while the export-driven Ready-Made Garment (RMG) sector experiences fluctuating demand, adding to the uncertainty.
The Bangladesh Bank's initiatives to tighten monetary policy and adjust interest rates have strained liquidity within the banking sector, ultimately impacting business investment and employment. Nevertheless, the economy showcases some encouraging elements. Remittances from Bangladeshi workers abroad and exports, particularly in the garment industry, continue to provide significant support, alleviating some of the adverse effects of the stringent monetary policy.
As a developing economy on a growth trajectory, Bangladesh presents numerous opportunities within its evolving economic landscape. Inflation, often influenced by variations in food and energy prices, may highlight these opportunities. This shifting economic context could also lead to a reconsideration of the traditional Phillips Curve relationship. In Bangladesh's case, high inflation typically arises from external shocks, such as spikes in global commodity prices, rather than from tight labour markets. The significance of the informal sector, considerable rural employment, and heavy dependence on agriculture complicate the interpretation of unemployment statistics. Additionally, policy-induced inflation -- such as adjustments to fuel prices -- can mask the underlying demand-pull inflation. Consequently, Bangladeshi policymakers may prioritize supply-side strategies over the inflation-unemployment trade-off, focusing on enhancing labour market flexibility and addressing structural barriers to growth.
The Way Forward
Bangladesh's current economic challenges and elevated inflation levels suggest that the country may need to be operating at its natural rate of unemployment (NAIRU). This underscores the need for thorough analyses of the labour market and inflation to refine NAIRU estimates. While current estimates range from 5% to 6%, this figure can vary considerably depending on changing economic conditions and policy shifts. It is essential for economists and policymakers to consistently update their models to accurately reflect the dynamic nature of Bangladesh's economy and remain aware of the potential implications of policy changes.
Dr. Soma Dhar is a Lecturer in Economics at Southern University, Bangladesh, and Dr. Arif Uz Zaman is an Additional Director at the Bangladesh Bank
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