Modeling and estimation of the natural rate of unemployment

The Phillips curve and natural rate concept are among the most influential and controversial macroeconomic topics of the post war period. Understanding these topics is important for the conduct of monetary policy. Current theoretical and empirical studies are lagging. This study provides both a theoretical and an empirical model to help understand the natural rate concept and the nature of inflation and unemployment tradeoff.; This study first provides a stochastic dynamic general equilibrium model for the natural rate of unemployment and short-run inflation unemployment tradeoff. Closed form solutions for inflation and unemployment dynamics are provided. This study also provides the impulse responses of those variables to a positive monetary shock and aggregate productivity shock. A positive monetary supply shock pushes inflation and unemployment to the opposite direction by increasing inflation gradually and decreasing unemployment instantaneously while a positive aggregate productivity shock pushes inflation and unemployment to the same direction by increasing inflation gradually and increasing unemployment instantaneously. The relationship between unemployment and inflation due to monetary shocks can be described as the Phillips curve. The simulation result shows that the curve is negatively sloped and S-shaped.; The study also uses a Structural Vector Autoregressive (SVAR) model to identify and analyze the short-run inflation unemployment dynamics and to estimate the natural rate of unemployment. For natural rate estimation, the only restriction imposed is that the natural rate is driven solely by “natural rate shocks”—shocks that change demographics, labor market institutions, etc. The results show that the estimated peaks and troughs of natural rates occur at the right times and are of plausible magnitude, which is consistent to the early findings by Gordon (1996, 1998) and Staiger, Stock and Watson (1997). The results also show that there is a clear short-run negative inflation and unemployment tradeoff due to demand shocks.