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New Keynesian Economics: NAIRU

Summary

During the second half of the 20th century, Keynesians were busy countering the neo-classicists and monetarists who were intruding onto their sacred ground: macroeconomics and the Phillips curve. New Keynesian Economics would keep on exploring market failure one breakdown at a time.

Main definitions and economists:

Unemployment and inflation:

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

The late 20th century saw a revival of the two defining currents of the 20th century: neoclassicism and Keynesianism. This afforded us New Keynesian Economics implementing a comprehensive microeconomic foundation into their macroeconomic models. It also allowed us to see what really held NCM and NKE currents together, as both began to do away with “theories of everything” and centred on what was truly important: just how perfect are markets, anyway? Whilst NCM attempted to prove they were perfect enough at least to warrant a ‘laissez faire’ approach, NKE centred on deconstructing market failure at micro level and then using this as a basis to warrant some, albeit much less, government intervention. We also saw another mathematical revival not seen since the advent of marginalism: econometrics. Much better statistical information and the spread of information and communication technologies led to the development of a whole science to determine the rules behind using the data you needed and discarding the rest to prove you were right and everybody else wrong.

New Keynesian Economics: Layard-Nickell’s NAIRU model