SummaryInflation and unemployment can be very harmful to the economy. However, knowing how a problem originates is always helpful when trying to fix it. This is the reason why economists have created an incredible amount of economic models that try to explain how inflation and unemployment behave. In this LP we take a look at a few economic models that explain, at least to some extent or in some given context, inflation and unemployment.
The Layard-Nickell NAIRU model emerged as a reply from New Keynesian Economics to the natural rate of unemployment, devised by Milton Friedman as a criticism of the Neoclassical Synthesis’ Phillips curve. This NAIRU model comes from an article entitled “Unemployment in Britain”, 1986, by Richard Layard and Stephen Nickell.
Indeed, the Layard-Nickell NAIRU model was able to explain the paradigm shift by moving away from assumptions of a perfectly competitive labour market into a model based on wage determination by means of trade union bargaining. In a perfectly competitive market, salaries and the prices of goods are traditionally determined by considering that the price of a product is fixed via its marginal cost (and, in the case of imperfect competition, a mark-up).
Trade unions will bargain with employers in order to get higher real wages for the workers. In the adjacent figure, it can be seen how the more people is employed and represented by trade unions, the higher real wages will be, thus marking the upward sloping BRW curve (Bargained Real Wages). The explanation is quite simple: from the workers point of view, higher employment rates mean lower opportunity costs derived from job seeking; on the other hand, employers are more likely to pay higher real wages when the economy is in expansion, since they don’t want to lower production (which would happen if workers went on strike.
Once trade unions have bargained an adequate real wages, the employer will fix prices (P) considering both costs of production and mark-ups (μ). If we assume real wages (W) as the only production cost (which is a reasonable assumption, since wages usually make up for a large portion of production costs), and we take into consideration also marginal productivity (MPL), we can find out what would be the price chosen by the employer:
and assuming the following:
we come up with the real wage:
This real wage (called Price-determined Real Wage, PRW) can be represented graphically as shown in the adjacent figure. Note that it’s a horizontal line, since for any given BRW, and at any employment level, the mark-up would be the same as well as the marginal productivity.
The reciprocal relation between wages and inflation is determined. The distance from the level of employment at equilibrium (L*) and the total labour force (LT), is the NAIRU. When, for example, the level of employment increases, trade unions will be able to negotiate higher real wages (A). Since the employer won’t be willing to accept a decrease in its profits, the mark-up will be maintained, which will raise prices. Therefore, an increase on employment, which will take the employment level higher than the NAIRU, will end-up increasing aggregate price-levels.
Anything that affects wage formation or unemployment rates is likely to affect inflation. Thus, fixing salaries above what they would be in a competitive labour market leads to higher prices, which increases inflation and reduces real wages. In a similar fashion, an increase in unemployment benefits drives salaries above what would naturally be determined, with similar effects. In this “battle of the mark-ups” between employers and employees, the NAIRU rises. This aims to explain the structural factors between some countries having a higher or lower “natural” unemployment rate than others. Empirically, it is interesting for example to note that only 15% of salaries in the US are fixed by trade unions, whereas in some countries of Europe, such as France, Italy or Spain, famed for having a naturally high NAIRU, almost 75% of employees are covered by a collective agreement.