Central banks employ theoretical constructs called “star variables” to guide monetary policy decisions. These unobservable economic indicators help policymakers understand relationships between growth, employment, and inflation.
The Three Star Variables
The first variable, potential output (y*), represents the economy’s sustainable maximum production capacity. This “speed limit” concept suggests that rapid growth exceeding potential generates inflationary pressure, while below-potential growth dampens inflation. Productivity directly influences this ceiling—improved productivity permits faster expansion without fuelling inflation.
The second variable, NAIRU (u*), identifies the unemployment rate that neither accelerates nor decelerates wage and price pressures. This natural rate concept emerged prominently during the 1970s economic analysis.
The neutral interest rate (r*) comprises the third variable, representing the policy rate that neither overstimulates nor excessively restrains economic demand. This metric indicates monetary policy’s overall stance.
Measurement Challenges
Unlike published inflation or employment statistics, these variables remain fundamentally unobservable. Central bankers employ spacecraft-tracking statistical methodologies to estimate them by detecting their effects on measurable economic indicators like wages and unemployment.
A Federal Reserve official noted these concepts help achieve “an equilibrium where resources are fully utilized,” despite their abstract nature.
Policy Application
Most central banks prioritize price stability; dual-mandate institutions like Australia’s RBA simultaneously target full employment. The RBA maintains a 2–3% inflation target across economic cycles. When unemployment approaches NAIRU levels, inflation typically stabilizes, signalling full employment alignment with potential output.
Understanding central bank objectives illuminates desired economic destinations but not the specific policy rate adjustments required. This reaction function—how policymakers adjust rates based on deviations from star variable targets—remains complex due to estimation uncertainties and transmission delays through the economy.
Caution often prevails; preserving institutional credibility sometimes outweighs taking potentially incorrect actions.
