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:

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 (MP_L), 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 (L^T), 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.

New Keynesian Economics argue that menu costs are the reason for price stickiness. Price stickiness, the suboptimal adjustment of prices in response to demand shocks, can result in business cycles. Gregory Mankiw proved in 1985 in his article “Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly” that sticky prices can be both privately efficient and socially inefficient. In fact, as Mankiw points out, even small menu costs can cause large welfare losses.

Mankiw uses a static model of a monopoly firm’s pricing decision, which starts by setting its price in advance and changes it ex post, but incurring in a small menu cost. The monopoly faces a constant cost function and an inverse demand function:

C = kqN

where

C: total nominal cost of production

q: quantity produced

k: constant

P = f(q)N

where

P: nominal price

N is a nominal scale variable, which denotes the exogenous level of aggregate demand. It can be regarded, for instance, as the overall price level. C and P increase proportionally to the level of nominal demand N.

Now, let c = C/N and p = P/N, which will turn the firm’s problem independent of aggregate demand:

c = kq

p = f(q)

In the figure below, we see the producer surplus (profits earned by the firm), equal to the rectangle between k and p_m. On the other hand, the excess value over the price paid represents consumer surplus, the triangle above profits. Total surplus, which represents welfare, is the sum of consumer and producer surplus.

The firm needs to set its price one period ahead based on expectations about future aggregate demand, being this price p_mN^e. If expectations are correct ex post, the observed price p₀ is p_m. If not, the observed price is p_m(N^e/N).

First scenario

The first case Mankiw examines is when aggregate demand N is lower than expected, and therefore p₀ is higher than p_m, as shown in the figure below. The producer surplus is lowered by B-A (since profits as seen before were equal to rectangle B plus the rectangle to its left), which is positive because p_m is by definition the profit-maximising price. Social welfare (or total surplus) is reduced by B+C, and therefore the reduction in welfare due to the contraction in aggregate demand is larger than the loss in the surplus of the firm.

Now, let’s suppose that the firm is capable of changing its price ex post, at a menu cost of z. The firm can then reduce its price from p₀ to p_m and obtain additional profits of B-A, which the firm will do if B-A > z. However, from the point of view of a social planner, the firm should lower its prize if and only if B+C > z. Let’s see Mankiw’s propositions on different outcomes:

-Proposition 1. Following a contraction in demand, if the firm cuts its price, then doing so is socially optimal (if it cuts it, is because B-A > z and therefore B+C > z+A+C > z).

-Proposition 2. Following a contraction in demand, if B+C > z > B-A, then the firm does not cut its price to p_m, even if it would be socially optimal (the inefficiency results because printing new menus result in an external benefit of C+A).

-Proposition 3. A contraction in aggregate demand reduces social welfare unambiguously, as shown by the sum of producer and consumer surplus. If the producer reduces its price, then the contraction only has the menu cost z. If the firm does not cut its price, then the contraction has the cost of B+C (probably much larger than z).

Second scenario

The second case Mankiw analyses is an expansion in aggregate demand (N > N^e), and therefore p₀ <p_m. Firstly, let’s see what happens when p₀ > k (N/N^e < p_m/k), as shown in our third figure. In this case, producer surplus is reduced by D-F, which is positive (p_m maximises the firm’s profits) and social welfare increases by E+F. The firm will reset its price if the increase in profits beats the menu cost. In other words, the firm will change its price if D-F > z.

-Proposition 4. If there is an expansion in demand and if the firm resets its price, social welfare decreases by the menu cost. If it doesn’t, total surplus increases by E+F.

Third scenario

Now, let’s see what happens if N/N^e > p_m/k, and therefore p₀ < k. Then, social welfare decreases by a positive or negative amount of I-J, which makes for an uncertain welfare effect. The firm’s profits, which are now negative, have been reduced by G+H+I. If G+H+I > z, then the firm will reset its price to p_m. Doing so would be socially optimal if I-J > z.

-Proposition 5. If the firm resets its price following the expansion in demand mentioned, social welfare (total surplus) will decrease by the menu cost z. If it doesn’t, total surplus does not decrease by more than the menu cost (if the firm doesn’t reset its price is because G+H+I < z, which implies that I-J < z-J-G-H < z and therefore the social welfare reduction I-J < z).

-Proposition 6 (as a summary of previous propositions). An expansion in aggregate demand may either increase welfare or reduce it, but never more than the menu cost. On the other hand, a contraction in aggregate demand will reduce welfare, possibly in an amount much larger than the menu cost.

Conclusion

To sum up, Mankiw demonstrates that private incentives ensures a high price adjustment when aggregate demand expands, but a small adjustment following a contraction in aggregate demand. From a social planner’s point of view, prices may be stuck too high, but never too low, which translates into downward price stickiness, although not into an upward rigidity. Mankiw also points out that a more complete model (general equilibrium) will probably show higher degrees of price stickiness, since interfirm purchases will exacerbate price rigidity. Therefore, the main conclusion of this paper (that small menu costs can translate into large inefficiency effects) would certainly remain in a general equilibrium model.

Regarding economic policies required to alleviate these problems, Mankiw explains how an active monetary policy is required. More particularly, he mentions policies that aim at the pricing mechanism, such as tax-based incomes policy and other supply-side policies.

Menu costs are costs that result from price changes. An easy way to understand menu costs is by means of a typical example: restaurants. When a restaurant manager wants to change prices, the cost of changing the menus (in order to show the new prices) must be taken into consideration. Therefore, the manager will need to assess whether the increase in prices will cover for the cost of printing new menus.

As Gregory Makiw demonstrates in his article “Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly”, 1985, this menu costs may lead to a non-socially optimal situation. Indeed, Mankiw’s menu costs model shows how higher menu costs may lead to a situation where prices remain unchanged, thus provoking so called price stickiness.

Contrary to what economists from the New Classical Macroeconomics think, which is that business cycles are originated by shifts in supply (which originate mainly from technological shocks), New Keynesian economists believe that business cycles are originated by price stickiness.  This price stickiness might be explained by menu costs, since the slow adjustment of the economy may explain business cycles.

There is a great debate over the following question: are these menu costs really large enough to cause business cycles? An article from Daniel Levy et al., “The Magnitude of Menu Costs: Direct Evidence from Large U.S. Supermarket Chains”, 1997, demonstrates, using empirical evidence, that these menu costs are indeed large enough to cause business cycles. The authors use store-level data from five multistore supermarket chains to directly measure menu costs. They find that the menu costs per store at those chains average more than 35% of net profit margins, which may be forming a barrier to price changes. When applying these findings to theoretical models of menu costs, the authors conclude that these menu costs are large enough to be capable of having macroeconomic significance. Furthermore, they believe that these menu costs may cause considerable nominal rigidity in other industries or markets, thus amplifying the effects on business cycles. These menu costs, they say, vary largely due to local and regional legislation, which may require, for instance, a separate price tag on each item, thus increasing menu costs.

Nicholas Gregory Mankiw, born in 1958, is an American economist and professor of Economics at Harvard University.

Mankiw has stood out as a well-known writer, whose best-selling and intermediate-level textbooks of economics, “Principles of Economics” and “Macroeconomics”, 2006, have sold over a million copies and been translated into seventy different languages. Mankiw has written articles in a regular basis at both academic journals and newspapers, such as “The American Economic Review”, “The New York Post” or “The Wall Street Post”. He is also a usual participant in many academic and policy debates.

He is an advocate of New Keynesian Economics, and his most important contributions have been in the fields of both microeconomics and macroeconomics, especially in the latter. Mankiw has dealt with subjects such as consumer’s behaviour, fiscal and monetary policy, financial markets behaviour and the determination of prices. In this last topic he has provided important work regarding menu cost.

Mankiw has also contributed in politics and was a chairman of the national Council of Economic Advisers, from 2003 to 2005, appointed by President George W. Bush.

George Arthur Akerlof, born in 1940, is an American economist and professor at University of California, Berkeley. He was awarded the Nobel Prize in Economic Sciences in 2001 along with Michael Spence and Joseph E. Stiglitz.

He is best known for his contributions to asymmetric information theories: study of transactions in which one of the parties has better information than the other one.  Adverse selection and moral hazard can result from the worst cases of asymmetric information in transactions between economic agents.

Akerlof’s key article on this subject is “The Market for Lemons: Quality Uncertainty and the Market Mechanism”, 1970, in which he develops a classical example of second hand car market in which the seller is the only one that truly has complete information about the quality of the car, to simply explain the risk of asymmetric information.

The New Keynesian Economics seeks to provide Keynesianism with microeconomic foundation support. This contemporary economic doctrine comes as a response to the critiques that Keynesianism received from the New Classical Macroeconomics (NCM) advocates.

New Keynesian Economics can be traced back to late 70s when the first foundations were built by economists such as Stanley Fischer, Edmund Phelps and John Taylor. One of the best economists to characterize the New Keynesian Economics is Gregory Mankiw, as he has made many contributions to this doctrine.

The main issue of this economic doctrine is to explain why changes in the aggregate price level are “sticky”. While in NCM competitive price-taking firms make choices on how much output to produce, and not at what price, in New Keynesian Economics monopolistically competitive firms set their own individual prices and accept the level of sales as a constraint. From a New Keynesian Economics point of view, two main arguments try to answer why aggregate prices fail to imitate the nominal GNP evolution. One of them is used both by NKE and NCM approach to macroeconomics, this is the assumption that economic agents, households and firms have rational expectations. However New Keynesian Economics considers that rational expectations become distorted as market failure arises from asymmetric information and imperfect competition. As economic agents can’t have a full scope of the economic reality their information will be limited, and there will be no reasons to believe that other agents will change their prices, and therefore maintain their expectations unchanged. Expectations are a crucial part for price determination, as they remain unaltered, so will the price, what leads to price rigidity. For firms, price rigidity may also come from what’s known as menu costs, this is, costs that result from price changes.

As a result of this price stickiness, which implies a slow adjustment of the economy and can lead to undesired levels of unemployment, government intervention is justified to stabilize the economy, by using both fiscal and monetary policies. However, this intervention ought to be minimal, much lower than New Keynesian Economics’s predecessors, the Neoclassical Synthesis, would argue for.