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“How might a country go about lowering its NAIRU? What are the welfare implications of so doing?”
In tackling this question, we will adopt a theoretical approach in the sense that we will focus on an economy and explain the determinants of NAIRU as well as the policy options. But it seems logical to first introduce the concept of NAIRU, or the non-accelerating inflation rate of unemployment, which will be interchangeably used with the “equilibrium rate of unemployment”.
According to Carlin and Soskice , the central concept of equilibrium unemployment can be defined as “the rate of unemployment at which the expected real wage that results from wage-setting decisions is equal to the real wage implied by price-setting decisions”.
Stiglitz argues that the NAIRU is used as a theory to understand the causes of inflation (predicting the changes in inflation rates) and is important because it enlightens the relation between unemployment and increasing inflation. The NAIRU corresponds to the rate of unemployment which is consistent with an unchanging inflation rate, and further reflects how the economy behaves out of equilibrium. Unless employment is at equilibrium level, inflation will increase or decrease until it reaches the NAIRU, the level of output and employment at which inflation is constant. In fact, Stiglitz explains that when unemployment is below the NAIRU, real wages demands are greater than the amount firms are willing to pay. At equilibrium, the behavior of wage-setters is compatible with that of the price-setters. His point is indeed that “if NAIRU exists, it must be changing over time” . What is more, Stiglitz identifies four phenomena that can change the NAIRU, namely changing demographics of the labor force, the productivity growth becoming more in line with worker expectations, an increase in the competitiveness of the labor and product market (through greater openness and trade), and finally hysterisis, which says that a higher NAIRU will generate an even higher one. He also discards the theory according to which productivity rate affects the equilibrium rate: productivity only has a temporary influence through the “wage-aspiration” effect.
According to Altig and Gomme , the NAIRU is thought to represent a “speed limit” for economic activity: “it measures a nation’s sustainable production capability”. If the economy grows faster than its resources can support over the long-run, that is when the unemployment rate falls below the NAIRU, then price pressure builds and inflation rate accelerates.
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It is argued that the NAIRU belongs to the basic model of imperfect competition (no market clearing process –labor market) and reflects an equilibrium at which inflation is constant . Such equilibrium means that price setters and wage setters are content at the current level of real wage and employment, and that they have no incentive to change their behavior. Furthermore, imperfect competition in the labor market pushes up the real wage that wage setters will accept, while imperfect competition in the product market pushes down the real wage consistent with the price-setting behavior. As a result, unemployment will have to be higher in order to achieve consistency between the claims of wage and price setters. What is more, the equilibrium is a medium run concept. The medium run is “the period during which wages and prices can respond to changes in output, employment and capital stock, during which the labor force is fixed and machines, equipment and technology constant” . In a medium run analysis, attention is focused on the behavior of wage and price setters. It should also be noted that, if the labor market is imperfectly competitive, then the equilibrium level of unemployment will include some involuntary unemployment, a concept reflecting the situation of an individual prepared to take a job at the going real wage who is unable to find a vacancy. If, however, the labor market and the product market are perfectly competitive, then wage and price setting curves are replaced by the supply of labor curve and the marginal product of labor curve. In such view, the equilibrium rate of unemployment is equal to the natural rate (in which there is no involuntary unemployment).
Mankiw argues that lowering the NAIRU could happen through a decrease in frictional unemployment (the time it takes to find a new job) . Policies such as government disseminating job vacancies or job retraining programs would apply. Mankiw also acknowledges the presence of “wait unemployment”, or the unemployment resulting from wage rigidity. Wage rigidity stands as the failure of wage to adjust until the supply for labor equals the demand. Such phenomenon can be explained by minimum wage laws, monopoly power of unions and the efficiency wage theory. Mankiw warns that if policies aim at lowering the rate of unemployment, they must aim at long-term unemployment, which accounts for a large amount of unemployment . What is more, these policies must be carefully targeted because long-term unemployment constitutes a small minority of those who become unemployed (in the short-term) .
Carlin and Soskice, who prefer “equilibrium rate of unemployment” to “NAIRU”, have looked in priority to open economies with imperfect competition, arguing that closed economies were “unrealistic” . In such economies, they argue, policy makers are likely to be constrained by external balance. Under these conditions, there is a range of unemployment rates at which inflation is constant (unlike in closed economy –unique NAIRU) and at which the economy can remain in the medium run . What’s more, there is an inverse relationship between the real exchange rate and the medium run level of output and unemployment illustrated by the equilibrium rate of unemployment. In the long-run, Carlin and Soskice argue, wealth effects and market pressures including exchange rate instability may push the economy toward the long-run equilibrium with current account balance. Any external or supply side change that shifts the BT curve or the equilibrium rate of unemployment curve leads to a change in the long-run sustainable unemployment rate . These are the policies on which we will try to focus throughout our analysis.
Governments can choose to lower the equilibrium rate of unemployment for two reasons: in order to run the economy at a lower rate of unemployment while keeping inflation constant, and in order to reduce inflation while holding unemployment constant.
According to Carlin and Soskice , policies that shift downward the bargained real wage curve (BRW) or upward the price-determined real wage (PRW) will achieve a sustainable reduction in unemployment, as in both cases compatibility between real wage claims of workers and real profit claims of firms will occur at a higher level of employment. In fact, shifts in BRW or PRW result in a shift of the long-run Philips curve to a new equilibrium rate of unemployment. Supply side fiscal measures, they argue , can lead to lower unemployment without the consequences of increasing inflation. One example are tax measures that reduce the government’s share of output per head and which enable the competing claims of the private sector to be reconciled at a lower level of unemployment . Lower taxation indeed reduces the wedge, or the difference between the real wage that workers receive and the real cost of labor to the firm. Such measures, in a closed economy, can therefore achieve a lower NAIRU by either lowering the BRW (i.e. by lowering the rates of direct taxation) or raising the PRW (i.e. by lowering the rates of indirect taxation).
The sustainable or long-run equilibrium rate of unemployment in an open economy depends on the determinants of wage and price setting behavior summarized in the competing claims equilibrium curve (CCE) and by the level of world aggregate demand which fixes the position of the BT. The intersection of the CCE and BT in the Salter-Swan diagram thus establishes the maximum sustainable level of output and employment consistent with the structure of the labor market price-setting, and external conditions.
An expansionary fiscal policy would shift the demand curve to the right which would lead to a new medium-run equilibrium where output is higher and unemployment lower, where È (competitiveness) is lower (i.e. a real appreciation) and the real wage higher, where there is a trade deficit and constant inflation . Under fixed exchange rates, adjustment to the new medium-run equilibrium is via “rising output and a temporary increase in inflation (relative to world inflation), which weakens È and dampens the expansion” . Under flexible rates, adjustment is via “an initial exchange rate appreciation that offsets the effect of the expansionary fiscal policy on output which is followed by a temporary fall in inflation (relative to world inflation) that boosts È and raises output” .
Government expenditure programs on industrial training can also achieve the goal of lowering the NAIRU. In fact, a more highly trained work-force will be characterized by higher productivity, which will shift the PRW upward. Furthermore, increased training will have the effect of lowering the BRW. Training programs substitute for additional cost of training for the firms, increase the pool of skilled labor available to the employer, and therefore reduce the union bargaining power. The reduction of unemployment benefit can also lead, in some cases, to lower unemployment but the empirical significance of the effects of changes in unemployment benefit are subject to debate.
In the medium run, the rate of inflation is determined by world inflation in a fixed exchange rate economy and by home’s monetary policy in a flexible exchange rate, which implies that the use of monetary policy has no pertinence in a fixed exchange rate economy . Following an expansionary monetary policy or a devaluation, output and employment expand due to the effect of the rise in competitiveness on net exports. This is, however, only a temporary effect: “since the devaluation has its effect by raising the real cost of imports, once wages and prices respond to this, there will be a bout of domestic wage and price inflation in excess of world inflation” . The higher inflation will reverse the boost to È and the cut in real wages and the economy will to its original position . In a flexible exchange rate economy with perfect capital mobility, a change in monetary policy, which works through its effects on the nominal exchange rate, leads to a shift along the AD curve and therefore does not change the NAIRU.
Supply side policies
The field that finally seems the more likely to bring about a lower NAIRU is supply-side policy. In fact, “supply shocks and supply-side policies are defined as those that shift either the wage-setting curve, the price-setting curve (for a given real exchange rate) or both” . In the open economy, a supply shock or policy is one that shifts the ERU curve and hence shifts the medium and long run equilibrium rate of unemployment.
To sum up, the WS curve will shift down if there is a fall in unemployment benefits (more precisely in the replacement ratio, which is the ratio of benefits to the average wage), if unions are given less legal protection, and if unions agree to exercise bargaining restraint (in the context of a wages accord). Under imperfect competition, market power of unions enables them to achieve higher bargained real wage than the real wage at which the individual worker would take the job. Such phenomenon does not occur under perfect competition. To the extent that an incomes policy can affect the level of expected real wage that unions are able to negotiate at each rate of unemployment, such policies will provide additional tools for lowering the NAIRU .
In a closed economy, the PS curve will shift if there is a change in taxes, in the mark-up due to a change in competitive conditions, or in efficiency. One example is the supply side effects of change in taxes: by altering the wedge between the real consumption wage and the real production wage, the government is able to alter the rate of employment at which the claims of unions and firms are consistent . The government’s share of real income claimed through the tax system is thus a choice variable.
Carlin and Soskice’s latest work argues that the “ability of government to improve the level of productivity through expenditures in training can lower the NAIRU” . Altig and Gomme make a good final qualification on the productivity argument by stating that “(labor market theory predicted) productivity gains lower the NAIRU down can only be true if such productivity developments fundamentally change the cost-benefit calculations that unemployed workers use when searching for jobs” .