Understanding Unemployment in Market Economies: NAIRU Model

NAIRU and Unemployment in Market Economies

According to the NAIRU (Non-Accelerating Inflation Rate of Unemployment) model, is the unemployment normally observed in market economies voluntary or involuntary? To answer this, we assume:

• An imperfect competition model where prices are set by firms.
• Analysis based on non-US industrialized economies.
• The Central Bank (CB) sets the real interest rate.
• Wages are set through collective bargaining or employer strategies.
• Money plays a passive role; inflation changes require money supply adjustments to maintain constant real aggregate demand and employment.

The NAIRU is a unique equilibrium unemployment rate where inflation is constant, and the expected negotiated wage equals the real wage set by firms targeting a specific price markup. Importantly, the NAIRU is not a market-clearing rate. There is involuntary unemployment at the NAIRU; some individuals willing to work at the existing real wage cannot find jobs. In the short run, aggregate demand determines employment and output levels.

Imperfect Competition and Involuntary Unemployment

In an imperfectly competitive labor market, unemployment at the NAIRU includes involuntary unemployment. Individuals are prepared to work at the current real wage but cannot find vacancies, as indicated by the labor supply curve.

Reducing the NAIRU Permanently

The equilibrium unemployment rate or NAIRU can be reduced permanently with policies that shift the Wage Setting (WS) and Price Setting (PS) curves to the right. A smaller wedge (e.g., decreased income tax) results in a lower NAIRU because a higher real consumption wage on the WS curve is consistent with equilibrium for price setters on a higher PS curve.

Factors Shifting the WS Curve Downward

• Decreased generosity of unemployment insurance.
• Reduced legal firing costs.
• Less legal protection for unions.
• Weaker unions.
• Unions exercise bargaining restraint (incomes policy).

Factors Shifting the PS Curve Upward

• Fall in the tax wedge (real product wage minus real consumption wage).
• Fall in markup.
• Rise in productivity.