NCPA - National Center for Policy Analysis

Unemployment, Inflation And The Minimum Wage

August 21, 2000

The Federal Reserve's Open Market Committee meets tomorrow and may raise interest rates again in response to low unemployment. If the Federal Reserve believes the rate of unemployment is below NAIRU -- the non-accelerating inflation rate of unemployment -- it will keep monetary policy tight and interest rates high.

NAIRU is the level of unemployment consistent with stable inflation. But it is not calculated on a monthly basis, and can only be estimated after the fact.

  • Press reports indicate the Federal Reserve puts NAIRU at 5 percent to 5.25 percent presently.
  • With 4 percent unemployment in the inflationary range, the Fed has been raising interest rates despite the lack of inflation in the Consumer Price Index.

Federal Reserve economist Peter Tulip says the largest single component of the NAIRU has been the minimum wage. The minimum wage prevents wages from falling when unemployment is high. Higher wage costs force employers to raise prices, thereby contributing to inflation.

  • Tulip concludes a 10 percent rise in the minimum wage raises the NAIRU by about half a percentage point.
  • Increases in the minimum wage in the 1960s and 1970s caused the NAIRU to almost double (see figure).
  • By the late 1960s, the minimum wage was responsible for more than half of the NAIRU.
  • But when the nominal (money) value of the minimum wage during the 1980s was frozen, NAIRU fell from more than 7 percent in 1980 to less than 5 percent by the end of the decade.

In response to the declining NAIRU, the Fed eased monetary policy, contributing to strong growth in the 1980s. When George Bush raised the minimum wage, the Fed tightened money policy in the early 1990s. Likewise, Bill Clinton's minimum wage increases are causing the NAIRU to rise.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, August 21, 2000.


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