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Inflation & Unemployment III: NAIRU

Summary

Inflation 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.

NCM's view:

NKE's view:

Prices and growth:

The term NAIRU (non-accelerating inflation rate of unemployment) is a term first used by James Tobin in 1980, in his article “Stabilization Policy Ten Years After”. It refers to the level of unemployment at which the economy settles if monetary policy is held stable. In these terms, it can be associated to Friedman’s natural rate of unemployment.

The NAIRU is based on empirical evidence regarding inflation and unemployment. Indeed, in most countries, inflation rises when unemployment is low because of the higher demand this implies; correspondingly, inflation falls when unemployment is high. This relation explains how unemployment may be above or below the NAIRU level not only because of the effects of monetary policy, but also because other factors such as production costs or trade unions negotiation processes. The Layard-Nickell NAIRU model explains it quite simply.

Even though the term NAIRU is usually merged in the economic literature with the term natural rate of unemployment, there are a few differences between the two. These differences are summarized in the following grid:

	Natural rate of unemployment (NRU)	NAIRU
Theoretical starting point	perfect competition	imperfect competition
Origins of deviation	solely in labour market rigidities	in labour market rigidities; supply-side inflation
Inflationist mechanism	monetary policies	monetary policies; supply-side inflation
Type of unemployment	voluntary (therefore NRU can be assimilated to level of full employment)	voluntary; involuntary
Uniqueness of equilibrium	unique	multiple equilibria when considering open economies

Now, let’s see how Richard Layard and Stephen Nickell’s model works.

Inflation & Unemployment III: NKE Inflation & Unemployment III: Layard-Nickell NAIRU model