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

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Introduction

"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) ...read more.

Middle

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. ...read more.

Conclusion

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). ...read more.

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