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The medium run (1–3 years) is when prices adjust but not all expectations do. Equilibrium is at the Non-Accelerating Inflation Rate of Unemployment (NAIRU), where inflation is stable. Deviations create wage and price pressures.
Show Phillips curve relating unemployment to inflation: below NAIRU, wage and price pressures build and raise inflation. Above NAIRU, disinflation occurs. NAIRU can be estimated from historical wage-price data.
Your prerequisites position you well for this concept. From short-run sticky-price equilibrium, you know that demand shocks can temporarily push unemployment below or above its natural rate while prices adjust slowly. From the natural rate hypothesis, you know that in the long run, the unemployment rate reverts to its structural level regardless of the inflation rate — money is neutral in the long run. The NAIRU (Non-Accelerating Inflation Rate of Unemployment) formalizes the medium-run version of this story: it is the unemployment rate consistent with *stable* inflation. Not zero inflation — just inflation that is neither rising nor falling.
The Phillips curve is the tool for understanding how the economy moves toward or away from NAIRU. The short-run Phillips curve shows a negative relationship between unemployment and inflation: when unemployment falls below NAIRU, tight labor markets give workers bargaining power, wages rise faster than productivity, firms pass costs onto prices, and inflation accelerates. When unemployment rises above NAIRU, the opposite occurs — wage growth moderates, price pressures ease, and inflation decelerates. NAIRU is the unemployment rate where these pressures exactly offset: workers' wage demands match the inflation rate firms expect, and actual inflation equals expected inflation. The economy is in a self-sustaining equilibrium.
The medium run — roughly 1 to 3 years — is the horizon over which this adjustment plays out. In the short run, firms have committed to prices and workers to wage contracts, so output and employment adjust to demand shocks while prices barely move (sticky prices). In the long run, all contracts adjust fully and money is neutral. The medium run is the interesting case: prices are adjusting, expectations are shifting, and the economy is en route from a short-run disequilibrium back toward NAIRU. Policy operates most powerfully in this window. A central bank that sees unemployment below NAIRU knows inflation is building and must decide whether to tighten now or wait; the cost of delay is that inflation expectations become embedded in wage-setting, shifting the Phillips curve upward and making disinflation more costly.
NAIRU is a theoretical concept, not a directly observable number. Economists estimate it from historical wage-price data, from structural models of labor market turnover, or by looking for the unemployment rate associated with stable inflation across different time periods. These estimates carry substantial uncertainty and change over time. The U.S. NAIRU was widely estimated near 6% in the 1990s; by the late 2010s, unemployment had fallen below 4% without triggering inflation, forcing estimates significantly lower. This variability is not an embarrassing admission of imprecision — it reflects genuine changes in labor market structure (union density, job matching technology, demographic composition) that shift the unemployment rate consistent with price stability. Treating NAIRU as a fixed constant is the single most common error in applying this framework to policy analysis.