Short Questions (250 words max)
1. What are the main differences between the ‘natural rate of unemployment’ and
the ‘NAIRU’ hypotheses?
The main differences between the two concepts relate to the fact that they belong to different models; the Friedman’s or the Neo-Classical model (the natural rate of unemployment) and the imperfect competition model developed by New Keynesian economists (NAIRU).
The existence of the differences between the NAIRU and the natural rate of unemployment, hence, depends on the theoretical perspective. For the Monetarist and Neo-Classical economists, the two concepts are identical because the economy is always at full employment. From the New Keynesian perspective, however, the equilibrium can settle at a level below the full employment; thus making the natural rate of unemployment a special case of NAIRU that occurs at full employment.
In both models, there is a point, at which the level of inflation is constant, that is it is possible to draw a vertical long run Philips curve in each model. The natural rate is the point of labour market clearing, where there is no voluntary unemployment and any temporary disequilibrium is quickly eliminated. The NAIRU, on the other hand, is the rate of unemployment at which the competing claims of labour and firms in the economy are consistent.
With NAIRU, the notion of market power and the effect of unemployment on the latter are significant. For example, the trade unions can bargain a higher real wage and the imperfectly competitive firms can mark-up marginal cost when setting the price. In the case of the natural rate of unemployment, the behaviour of workers and firms are central. The rate of inflation is constant due to competitive behaviour of agents in labour and product markets.
- Identify at least three reasons why the real wage could be higher than the level that clears the labour market.
When the real wage is higher than the level that clears the market, there is excess supply of labour, which is caused either by the fact that firms are not free to choose the wage or if it is in the interest of the firm to pay a higher wage.