What Labor Market Theory Tells Us about the "New Economy"

The average unemployment rate for 1997 was 4.9 percent, well below most estimates of the nonaccelerating inflation rate of unemployment (NAIRU).1 One would therefore have expected to see an increase in inflation in 1997; yet, as measured by the CPI, inflation fell from 3.3 percent to 1.7 percent (December to December). This phenomenon of low unemployment accompanied by falling inflation has prompted some observers to claim that the economy is now operating under a new set of rules. The explanation is often couched in terms of a favorable technology shock which has permanently lowered the NAIRU. This article asks whether economic theory supports the claim that a technology shock can change the natural rate of unemployment. This term is preferred to NAIRU in the context of the theory used below, which is silent on the determination of nominal magnitudes like the price level and inflation.2 Rather, the theory speaks to the determination of real as opposed to nominal wages (that is, in terms of goods rather than dollars). Consequently, changes in the natural rate of unemployment need not have any repercussions for inflation. Proponents of the view that a technology shock can change the natural rate of unemployment often rely, at least informally, on neoclassical labor demand and supply. A positive improvement in technology shifts labor supply to the right, since firms find all workers more productive. In equilibrium, total hours worked and output rise without contributing to inflation, since improved technology raises the real wage rate. However, as shown below, the neoclassical model cannot explain unemployment per se. Any individual who does not work has chosen not to work and so cannot be described as unemployed. Next, a search model of unemployment is developed. This environment is characterized by imperfect information: Workers do not know the locations of well-paying jobs, and firms do not know the identities of highly productive workers. Consequently, workers must seek out firms in order to receive wage offers,