How well do they account for the experience of unemployment in OECD economies in the past twenty years?

University Degree Business and Administrative studies

“The NAIRU is an equilibrium rate of unemployment, which depends upon the labour market characteristics of the economy. Unfortunately it appears to change in ways that are unrelated to the structure of the labour market.” Explain the natural rate of unemployment and NAIRU concepts of equilibrium unemployment. How well do they account for the experience of unemployment in OECD economies in the past twenty years?

Theories about unemployment, it’s causes and possible cures differ greatly depending on the set of assumptions adapted.. The classical theory and Strong Say’s Law imply that the economy will always be at full employment (voluntary level of unemployment) with a vertical supply curve, where prices and wages are flexible and can respond to changes in supply and demand immediately. For instance, an increase in money supply will have no effect on output and a change in price will be immediately matched by a change in money wages, as the workers care only about their real wages. The model assumes perfect competition, absence of money illusion and price and wage flexibility. Keynes, on the other hand, believed that assuming underemployment and underproduction in the short run, the supply curve is horizontal and changes in the money supply will have no effect on prices but only lead to an increase in employment. Keynes assumed money wage stickiness and money illusion. In both theories there is no trade off between inflation and unemployment, however the empirical observation named Phillips curve suggested that there is a relationship between the two. The aim of this essay is to explain NRU (market clearing rate of unemployment) and NAIRU (equilibrium rate where inflation is stable but there still can be some involuntary unemployment), distinguish between the two and comment on how useful these concepts are in explaining such a phenomena as OECD economies’ unemployment, where unemployment continued to grow even when inflation was stabilised.

In General Theory there is very little explanation about the determination of the movement in money wages as Keynes simply relied on the perfect competition model of price determination. However, real wages were found to move pro- cyclically rather than counter-cyclically and the account of inflation was required. The Keynesian- neoclassical synthesis relies on IS-LM model of general equilibrium, Phillips curve and mark-up pricing (P=W). Those three equations will determine u*- labour market equilibrium rate of unemployment, where labour market does not determine the level of employment (fixed by AD), but the rate of wage inflation (0 at u*). Implication of this model is that there is a trade off and government can choose a lower level of u but with higher but finite rate of inflation. This model worked until 2nd half of 1960s when it was broken down in the USA where inflation kept rising even after unemployment had stopped falling. The model was modified by Friedman to account for expectations and the fact that money illusion does not last forever. He believed that while markets clear in the long-run (NRU) they do not necessarily clear at full employment in the short run because of lack of perfect information on the part of agents, thus incorporating both elements of classical and Keynesian analysis. The model assumes perfectly competitive firms producing at profit maximising level of output w/p=MPL. If the level of price is greater that the expected level of price the workers will supply E0 but will do so because they believe real wage is actually w0 not w*, as shown below:

Friedman believed that this temporary mistake arises because it is far more difficult for workers to correctly assess the level of real wages in terms of price index of consumption.

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Friedman believed that this temporary mistake arises because it is far more difficult for workers to correctly assess the level of real wages in terms of price index of consumption.

Overall, the model suggests that markets clear in the long run with expectations fulfilled, where output and employment in the labour market are determined as in the classical model, but not necessarily in the short run. The Market-clearing rate of unemployment is the Natural Rate of Unemployment (NRU), where unemployment is entirely voluntary (choice of individuals to engage in search activities- frictional u). As in the classical model the rate of inflation is stable at NRU with vertical Phillips Curve and neutrality of money. One point to note (extended by Lucas) is that assuming rational expectations, only unanticipated increase in the price level could lead workers to work more, and at NRU expectations of all market participants are fulfilled (in other words there is correct information between workers and firms). A policy implication of this model is that if the level of unemployment is below NRU inflation will keep accelerating.

The model analysed above holds since markets do clear in the long run at some rate which involves only voluntary unemployment; thus by assuming perfect competition it ignores the possible imperfections of the market which can lead to involuntary unemployment even at the equilibrium rate.

Imperfect competition model assumes that wages and prices are set not by the market but by wage-setters and price-setters, i.e. through collective bargaining negotiations or as the result of employer’s strategy (can produce at MPL> w/p). The level of unemployment depends on level of aggregate demand and although the government can choose the level of u by adjusting AD it may have to face the consequence of rising inflation. Imperfect competition model provides quite different rationalisation for the genesis of inflation: inflation arises from the existence of inconsistent claims on the economy’s real income, not from increase in money supply. In general, there is a unique level of unemployment at which the competing claims of wage-setters and price-setters are reconciled and inflation is constant. This equilibrium rate is referred to as NAIRU (non-accelerating rate of inflation). For example, if at a given level of employment the real wage desired by workers is not equal to the real wage set by firms (as a desired profit margin) and real wage and real profit claims sum to more than output per worker, then higher unemployment is needed to dampen workers bargaining power (e.g. union). Thus according to this model at NAIRU inflation is stable, however it is not necessarily a market-clearing rate (NRU) as the wage can be set above the market clearing level and there can be involuntary unemployment (workers are prepared to work at existing real wage but cannot get a job). Inflation here is mainly viewed as a labour market phenomena and can be explained well by unemployment in particular.

Where under perfect competition price is set in relation to cost (p=mc, w/p=mpl), there is no general agreement on how prices are set in imperfect competition; however the findings of Coutts, Tobin and Bill suggest that the price-determined real wage curve is flat, i.e. prices do not respond much to change in demand. In Figure 2 below it is shown that NAIRU is En level of employment where BRW (bargained real wage)= PRW (price-determined real wage), i.e. no inconsistency between competing claims and the expectations of all parties are fully satisfied.

There are only two ways the inconsistency of claims can be resolved without leading to rising inflation. Firstly, unemployment can be pushed up to the equilibrium rate, e.g. through the weakening of the position of labour and reducing BRW to PRW. Secondly, NAIRU itself can be shifted to a lower rate of unemployment either through shifts of BRW (down) or PRW (up) curves.

There are clear similarities between NAIRU and NRU, as they both have the same Philips curve equation; short-run being indexed by expected inflation and long run being vertical. However, the underlying micro foundations and mechanisms through which inflation is generated are different. In imperfect competition model it is the market power of wage-settlers and price-settlers, which enable them to achieve BRW and PRW. Whereas in Friedman’s model conditions p=mc and w/p=mpl must be satisfied and there are not supernormal profits (e.g. can’t have monopoly). The initiating factor of inflation in the imperfect competition model is the change in AD level, which shifts the level of employment away form NAIRU, and any change in the level of employment creates a change in the relative bargaining power of the parties. In this model money supply is used to vary AD and keep the level of employment constant. In Friedman’s model, the initiating factor is the monetary impulse. Unexpected rise in the price level creates misperception on behalf of the workers, which in the short run enables the supply of labour to rise and additional output demanded to be produced.

Friedman’s model and NRU does not account that well for the experience of unemployment in OECD economies in the past twenty years because even at moments when inflation was stabilised unemployment was still rising. One also needs to question the relevance of the long-run market clearing equilibrium. As Gailbraith points out ‘Information may be asymmetric. Competition may be monopolistic. Nonlinearities and even chaos are possible.

Equilibria may be multiple or continuous. In such cases, the long-run equilibrium may be undetermined or incalculable or beyond achievement’. To put it another way, the future in the long run may be inherently unpredictable. The imperfect competition model and NAIRU seem like a more useful concept as it takes into account the fact that the equilibrium rate will depend on socio-economic variables such as different benefit systems or wage-bargaining arrangements. It also incorporates explanations for the real wage being set higher than the market-clearing rate. For instance, efficiency wage theory together with co-ordination problems and adjustment costs suggest that firms might want to pay workers more to motivate them; furthermore working conditions, including wage, are negotiated periodically but not frequently because of the cost involved.

In late 60s, early 70s demand was stocked up and Δm rose, dragging up inflation and employment. In 1973-74 the huge rise in the price of commodities (oil), mostly supplied from outside OECD followed. Layard, Nickell and Jackman (LNJ) suggest that this together with greater union militancy in Europe raised the NAIRU. After the second oil shock of 79-80 inflation was decided to be reduced, and although inflation was coming down, it was at a rate slower than expected given the high level of unemployment. LNJ suggest hysteresis as an explanation, where unemployment in this period depends on unemployment in the last period. Hysteresis means that once u has risen it cannot be brought down at once to NAIRU without a permanent increase in inflation but can only be reduced gradually. Thus, the persistence in OECD countries can be explained through institutional factors (e.g. benefits being open ended in duration), labour market rigidities (strict firing regulations etc) or hysteresis and development of long-term unemployed who might be viewed as unemployable by firms. Since the high unemployment from 1970s onward cannot be explained just in terms of inflation, some tried to explain it by other labour market explanations such as shown above which will induce NAIRU to change itself. However, others, e.g. Rowthorn, suggested that it is not just labour market characteristics of the economy that determines NAIRU. Rowthorn shows that in their model, LNJ make the assumption that labour and physical capital are close substitutes and the elasticity of substitution between the two is equal to unity. According to the LNJ model, the NAIRU is completely unaffected by variations in aggregate capital stock, aggregate labour supply or technical progress. For instance, if there is investment in new physical capital, trade unions will respond by forcing wages up to the point where the loss of jobs on existing equipment is exactly equal to the extra jobs created on new equipment. Rowthorn shows in his paper that using Cobb-Douglas function is a restrictive and unrealistic assumption to make and if one replaces it to assume that the elasticity of substitution between labour and capital is below unity, it has different policy implications. The policy implication will be that measures to stimulate investment may have an important role in reducing unemployment, where as growth in labour supply or technical progress with a labour augmenting bias will cause a permanent rise in unemployment unless they are offset by additional investment. Rowthorn conclusion suggest that, although labour market characteristics are important in explaining NAIRU and the persistence of high unemployment since 1970s oil shocks even when inflation was stabilised, a major force behind persistent unemployment may also be inadequate growth in capital stock. Such a conclusion, he shows, is in line with empirical evidence on the link between investment and job creation, which indicates that employment performance has deteriorated most since 1973 in those OECD countries which have experienced the greatest fall in investment rate.

It has to be noted, that the whole concept of NAIRU and its determinants has been subject to much controversy between economists and no agreement on what it depends on and what its level actually is has been reached for 30 years. Some suggest that it is a useful concept to understand the causes of inflation and as a general guideline for thinking about macroeconomic policy. For instance, Stiglitz belief that the changes in the inflation rate are, in a large part, a labour market phenomenon whose magnitude can be proxied by unemployment rate, has been successful empirically. Furthermore, he points out that NAIRU is also a useful concept because it helps to understand its changes overtime. He believes that changes of NAIRU over time (Stiglitz believes it has fallen from 1984 onwards) can be explained by the changing demographics of the labour force, the fact that the productivity growth has become more in line with the worker expectations and the general increase in the competitiveness of the labour and product markets (globalisation, decreasing rates of unionisation etc).

Other, e.g. Galbraith, believe that to hold on to a concept in the face of 20 years of unexplained variation and to fail to agree on procedural issues represents an embarrassment to the reputation of the profession of economists. He criticises the Philips curve theory for its lack of theoretical justification and the fact that it is based purely in empirical observations. If the Phillips curve fails empirically then the notion of NRU and NAIRU also lose their meaning. He also believes that when looking at relationship between inflation and unemployment for Europe on average and taking data as a whole there is only a very modest inverse relationship. Galbraith expresses scepticism in the notion of NAIRU by suggesting that because accelerations in inflation in 1970s was led by commodities, especially oil, or by import price devaluation, and not by wage inflation, economists might as well develop general equilibrium theories proposing NAIROP (non-inflation-accelerating rate of oil production). Furthermore, he believes that because of the instability of NAIRU across time and countries, it is even more uncertain as a cencept.

Overall, after the discussion of the notions of NRU and NAIRU, it is clear that there is much confusion about the exact means of estimating it and about its determinants. However, the uncertainty around it does not prevent one to draw possible explanations about unemployment. The supply shocks in the 1970s led to rising inflation and rising unemployment, and although inflation was stabilised in the 1980s one needs to explain the persistence of high unemployment. One of the possible explanations is hysteresis, that is unemployment in this period depends on unemployment in the previous, thus is slow to fall. If there are long-term unemployed workers they might be seen as unemployable, as the shorter your duration of unemployment the more willing the firms will be to employ you. Other explanations for OECD countries include that of great union militancy, labour market rigidities (high firing costs etc), insider-outsider effect, generous benefit system, low investment rate etc. Although these explanations might account well for the persistence of unemployment, it seems like economists are trying to come up with different explanations for the persistence of unemployment in Europe in the 1970s rather than using the general theory NAIRU due to its lack of theoretical justification and a unified theory (how it is derived and determined).

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