Hysteresis and the NAIRU
Since the early 1970s the natural rate of unemployment ‘seems to have taken
a wild ride’ in OECD countries. For OECD countries in general, unemployment
in the 1980s and 90s was higher than during the ‘Golden Age’ of the
1950–73 period. The steadily rising unemployment rates appear to have their
origins in the two OPEC oil price shocks in 1973 and 1979 respectively
(Phelps and Zoega, 1998) and in the case of the European OECD countries,
unemployment that averaged 1.7 per cent in the early 1960s rose to 11 per
cent by the mid-1990s. This high average also hides the large dispersion of
unemployment rates across the European countries (Blanchard and Wolfers,
2000). Gordon’s (1997, 1998) estimates show that the US natural rate of
unemployment has also varied during this same period although the long-run
unemployment repercussions of the 1980s recessions appear to have been
much more persistent in Europe than in the USA. Figure 7.10 shows the
standardized unemployment rates for the USA and OECD Europe for the
period 1972–98. While unemployment in OECD Europe was less than US
unemployment until the early 1980s, since then European unemployment has
remained stubbornly high while it has fallen in the USA.
While the problem of inflation was a major policy concern during the
1970s and early 1980s, by the mid-1980s economists were once again turning
their attention to the problem of unemployment, in particular the rise in the
estimated NAIRU (see Bean et al., 1986; Fitoussi and Phelps, 1988; Summers,
1990; Layard et al., 1991, 1994; Bean, 1994; Cross, 1995; Nickell,
1997, 1998; Siebert, 1997; Katz and Krueger, 1999; Blanchard and Wolfers,
2000; Fitoussi et al., 2000; Hall, 2003).
While estimates of the NAIRU are obviously subject to uncertainty given
the broad range of determinants, recent OECD estimates shown in Table 7.1
indicate the much superior performance of the US economy compared to the
euro area and G7 countries.
During the late 1960s, Friedman and Phelps independently put forward
expectations-augmented models of the Phillips curve. In Friedman’s model
the market-clearing rate of unemployment is called the natural rate of unemployment
and is associated with a stable rate of inflation. As we noted in
Chapter 4, many economists (especially those sympathetic to Keynesianism)
prefer to use the ‘NAIRU’ concept (non-accelerating inflation rate of unemployment),
rather than ‘natural rate’ when discussing long-run unemployment.
The NAIRU terminology was first introduced by Modigliani and Papademos
Source: ‘Labour market performance and the OECD jobs strategy’, OECD, June 1999,
Figure 7.10 Standardized unemployment rates for North America (USA
and Canada) and OECD Europe, 1972–98
% 12
11
10
9
8
7
6
5
4
3
2
1
0
1972 74 76 78 80 82 84 86 88 90 92 94 96 98
North America
OECD Europe
Table 7.1 NAIRU estimates for the G7 countries and the euro area
Country/area 1980 1985 1990 1995 1999
Canada 8.9 10.1 9.0 8.8 7.7
France 5.8 6.5 9.3 10.3 9.5
Germany 3.3 4.4 5.3 6.7 6.9
Italy 6.8 7.8 9.1 10.0 10.4
Japan 1.9 2.7 2.2 2.9 4.0
UK 4.4 8.1 8.6 6.9 7.0
USA 6.1 5.6 5.4 5.3 5.2
Euro area 5.5 7.1 8.8 9.2 8.8
Source: ‘Revised OECD Measures of Structural Unemployment’, OECD, December 2000.
(1975) as ‘NIRU’ (non-inflationary rate of unemployment), defined as ‘a rate
such that, as long as unemployment is above it, inflation can be expected to
decline’. The NAIRU acronym was introduced by James Tobin (1980c) and
has since been used to describe estimates of the natural rate of unemployment
(see Cross et al., 1993; Cross, 1995). However, according to King (1999):
the natural rate of unemployment and the NAIRU are quite different concepts. The
former describes a real equilibrium determined by the structural characteristics of
the labour and product markets – the grinding out of Friedman’s Walrasian general
equilibrium system (modified, if necessary, by non-Walrasian features of
labour markets such as imperfect competition, search behaviour and efficiency
wages). It exists independently of the inflation rate. In contrast, the latter, as well
as being affected by these structural characteristics, is also affected by the gradual
adjustment of the economy to past economic shocks that determine the path of
inflation. Because it is defined as the unemployment rate at which there is no
immediate pressure for a change in the inflation rate, it is a reduced form – not a
structural – variable.
Therefore, the NAIRU concept takes into account inertia in the system which
allows a protracted response of the economy to various economic shocks.
Another way to distinguish between these concepts relates to their
microfoundations. Friedman’s natural rate is a market-clearing concept,
whereas the NAIRU is that rate of unemployment which generates consistency
between the target real wage of workers and the feasible real wage
determined by labour productivity and the size of a firm’s mark-up. Since the
NAIRU is determined by the balance of power between workers and firms,
the microfoundations of the NAIRU relate to theories of imperfect competition
in the labour and product markets (see Carlin and Soskice, 1990; Layard
et al., 1991). However, while recognizing these differences between the concepts
of the natural rate and the NAIRU, Ball and Mankiw (2002) argue that
NAIRU is ‘approximately a synonym for the natural rate of unemployment’.
Therefore, in the discussion that follows we will assume that the two concepts
can be used interchangeably.
According to Friedman’s natural rate hypothesis, fluctuations of aggregate
demand cannot exercise any influence over the natural rate of unemployment,
which is determined by real supply-side influences. The conventional natural
rate view allows monetary and other demand shocks to shift aggregate demand,
thereby influencing the actual rate of unemployment in the short run.
But, as inflationary expectations adjust, unemployment returns to its long-run
equilibrium (natural) value. In new classical models, if the change in aggregate
demand is unanticipated, the combined effect of perfectly flexible prices
and rational expectations ensures that unemployment will quickly return to
its natural rate.
This conventional view is illustrated in Figure 7.11, where the natural rate
of unemployment (UN) is given by point A. Any decline in aggregate demand
will increase the actual rate of unemployment temporarily to point B, while
an expansion of aggregate demand will lower actual unemployment and will
Figure 7.11 The ‘natural rate’ view of the relationship between actual
unemployment and equilibrium unemployment
A
Expansionary demand shock O Contractionary demand shock
UN
B
C
Rising rate
of inflation
Falling rate
of inflation
Unemployment
move the economy temporarily to point C. However, in the long run, unemployment
returns to the natural rate of unemployment at point A.
The dramatic rise in unemployment rates, particularly in Europe during the
1980s, suggested that this conventional view of the natural rate of unemployment
(or NAIRU) must be wrong. It seems that the NAIRU must have risen,
and estimates made by econometricians, such as those presented in Table 7.1,
confirm this view. Several explanations have been put forward to explain
these higher levels of unemployment. One view explains it as a result of
specific policy changes that have reduced the flexibility of the labour market;
more powerful trade unions, higher unemployment compensation and longer
duration of benefits, minimum wage laws, excessive regulations, employment
protection, and higher taxation are, or have been, favourite candidates (see
Minford, 1991; Nickell, 1997; Siebert, 1997; Ljungquist and Sargent, 1998;
Fitoussi et al., 2000; Roed and Zhang, 2003). However, while some of these
factors may account for rising unemployment in the 1970s, many economists
do not believe that they offer a complete explanation of the unemployment
experienced in the 1980s and 1990s (union power, for example, has been
significantly reduced in the UK and has never been a major factor in the US
economy)
The simultaneous rise in the actual and equilibrium rates of unemployment
has led some new Keynesian economists to explore a second explanation
which allows aggregate demand to influence the natural rate (or NAIRU).
Models which embody the idea that the natural rate depends on the history of
the equilibrium rate are called ‘hysteresis’ theories. It was Phelps (1972) who
first suggested that the natural rate equilibrium will be partly influenced by
the path taken to reach equilibrium. Phelps called this path dependence
‘hysteresis’, a term borrowed from physics, where it is used to describe the
lagging of magnetic induction behind the source of magnetism (see Cross,
1995).
In hysteresis models the natural rate of unemployment will increase if the
actual rate of unemployment in the previous period exceeds the former time
period’s natural rate (Hargreaves-Heap, 1980). This can be expressed as
follows:
UNt = UNt−1 + a(Ut−1 −UNt−1) + bt (7.14)
In equation (7.14) UNt is the natural rate of unemployment at time t, UNt–1 is
the previous period’s natural rate of unemployment, Ut–1 is the previous
period’s actual rate of unemployment and bt captures other influences on the
natural rate such as unemployment compensation. If we assume bt = 0, then
equation (7.14) can be rearranged as (7.15):
UNt −UNt−1 = a(Ut−1 −UNt−1) (7.15)
From equation (7.15) it can be seen that UNt > UNt–1 if Ut–1 > UNt–1. In other
words, the shifting actual rate of unemployment acts like a magnet, pulling
the natural rate of unemployment in the same direction. Thus while it may be
reasonable to argue that aggregate demand does not affect UN in the short run,
it is likely that prolonged periods of abnormally high or low economic activity
will shift the natural rate of unemployment.
The impact of hysteresis is illustrated in Figure 7.12. The initial equilibrium
unemployment rate is represented by point A. If the economy is subject
to a negative aggregate demand shock, output falls and unemployment rises
to point B. When the economy recovers from recession, the unemployment
rate does not return to point A. Instead, because of hysteresis effects, the new
NAIRU is at point C. If the economy is now subject to a positive aggregate
demand shock, unemployment falls to point D. When the economy returns to
equilibrium the NAIRU has now fallen to point E. A further recession traces
out a path for this economy through points F to G. In other words, the
NAIRU is influenced by the actual rate of unemployment which itself is
determined mainly by aggregate demand.
Figure 7.12 The hysteresis view of a ‘time-varying’ NAIRU
A
Expansionary demand shock O Contractionary demand shock
B
C
Rising rate
of inflation
Falling rate
of inflation
Unemployment
F
E
G
D
Theories of hysteresis fall into two main categories, namely duration theories
and insider–outsider theories. Duration theories point out that, when Ut >
UNt, the problem of structural unemployment is exacerbated because the unemployed
suffer a depreciation of their human capital (skills) and as a result
become increasingly unemployable. A high rate of unemployment also tends to
generate an increasing number of long-term unemployed who exercise little
influence on wage bargaining, which also raises the NAIRU. Insider–outsider
theories emphasize the power of insiders which prevents the downward adjustment
of wages in the face of high unemployment. As a result, outsiders are
unable to price their way back into jobs following a rise in unemployment (see
Blanchard and Summers, 1986, 1988). If hysteresis effects are important, the
sacrifice ratio associated with disinflation and recessions is much greater than
is suggested by the original natural rate hypothesis, since high unemployment
will tend to persist (for an extended discussion of the issues raised in this
section, the reader is referred to Cross, 1988; Cross et al., 1993, Layard et al.,
1991; Blanchard and Katz, 1997; Gordon, 2003).
Another distinctive approach to explaining movements in the equilibrium
rate of unemployment over time has been developed by Edmund Phelps and
his co-researchers. In a series of books and papers Phelps has sought to
construct an endogenous theory of the natural rate of unemployment where
‘the equilibrium path of unemployment is driven by the natural rate that is a
variable of the system rather than a constant or a forcing function of time …
hence a moving-natural-rate theory holds the solution to the mystery of what
is behind the shifts and long swings of the unemployment rate’ (Phelps, 1994;
see also Fitoussi and Phelps, 1988; Phelps and Zoega, 1998; Phelps, 2000).
While in Friedman’s natural rate model equilibrium unemployment can change
due to supply-side influences, in Phelps’s dynamic intertemporal non-monetary
equilibrium model it is real demand shocks that are ‘the great movers
and shakers of the economy’s equilibrium path’, although real supply (energy)
shocks also play an important role. Phelps (1990, 1994) classifies his
approach to explaining unemployment as both ‘modern’ and ‘structuralist’,
although it does contain both neoclassical (the role of real interest rates
determined in the capital market), Austrian (the effect of the rate of interest
on the supply of output) and new Keynesian elements (asymmetric information
and efficiency wages). Phelps highlights the impact on the path of the
equilibrium unemployment rate of real influences such as technology, preferences,
social values and institutions. As Phelps (1994) recalls, by the 1980s
he had decided that any chance of accounting for the major swings in economic
activity since the war would require:
abandoning the simplification of a natural rate unemployment rate invariant to
non-monetary (not just monetary) macro shocks in favour of models making the
equilibrium rate an endogenous variable determined by a variety of non-monetary
forces … the longer booms and slumps … must be explained largely as
displacements of the equilibrium path of unemployment itself, not as deviations of
unemployment around an impervious equilibrium path.
In looking for the causes of what Fitoussi et al. (2000) call ‘the great slump’,
that is, the upward shift of equilibrium unemployment rates in the 1980s, the
chief suspects identified are five OECD-wide real shocks to business profitability
and worker’s incentives (see Phelps, 1994), namely:
1. reduced expectations of productivity growth, hence increased effective
cost of capital;
2. an increase in the expected real interest rate which also raises the effective
cost of capital;
3. an increase in services from workers private assets (see Phelps, 2000);
4. an increase in social entitlements relative to after-tax real wages resulting
from the 1970s productivity slowdown and expansion of the welfare
state;
In the Phelps (1994) model the main driving force behind the rise of the
NAIRU is the increase in real interest rates that occurred across the OECD
countries after the mid-1970s and on into the 1980s (Blanchard and Wolfers,
2000). The rise in world real interest rates, to a large extent induced by US
fiscal expansion in the early 1980s, lowered incentives to accumulate capital,
and, for a given real wage, led to a reduction of labour demand. The high real
interest rate which induced an appreciation of the US dollar (real depreciation
of European currencies) during this period also led to an increase in
European price mark-ups (firms do not lower their export prices in proportion
to the depreciation) and, in consequence, this led to a reduction in labour
demand and a rise in the equilibrium rate of unemployment. For example,
Phelps and Zoega (1998, p. 788) find a very strong correlation between the
world real rate of interest and UK unemployment for the period 1975–95.
Note that in contrast to real business cycle models, where changes in the real
interest rate influence the supply of labour through the intertemporal labour
substitution hypothesis, in Phelps’s model changes in the real interest affect
the demand for labour (for a critique see Madsen, 1998).
While the impact of real shocks as an explanation of increases in the broad
evolution of European unemployment is persuasive, Blanchard and Wolfers
(2000) argue that ‘there is insufficient heterogeneity in these shocks to explain
cross-country differences … Adverse shocks can potentially explain the
general increase in unemployment. Differences in institutions can potentially
explain differences in outcomes across countries.’ Therefore, a more convincing
story of the evolution of the NAIRU in Europe must involve the interaction
of observable real shocks combined with a recognition of the institutional
diversity present across European countries (see Nickell, 1997; and Layard
and Nickell, 1998).
Since the early 1970s the natural rate of unemployment ‘seems to have taken
a wild ride’ in OECD countries. For OECD countries in general, unemployment
in the 1980s and 90s was higher than during the ‘Golden Age’ of the
1950–73 period. The steadily rising unemployment rates appear to have their
origins in the two OPEC oil price shocks in 1973 and 1979 respectively
(Phelps and Zoega, 1998) and in the case of the European OECD countries,
unemployment that averaged 1.7 per cent in the early 1960s rose to 11 per
cent by the mid-1990s. This high average also hides the large dispersion of
unemployment rates across the European countries (Blanchard and Wolfers,
2000). Gordon’s (1997, 1998) estimates show that the US natural rate of
unemployment has also varied during this same period although the long-run
unemployment repercussions of the 1980s recessions appear to have been
much more persistent in Europe than in the USA. Figure 7.10 shows the
standardized unemployment rates for the USA and OECD Europe for the
period 1972–98. While unemployment in OECD Europe was less than US
unemployment until the early 1980s, since then European unemployment has
remained stubbornly high while it has fallen in the USA.
While the problem of inflation was a major policy concern during the
1970s and early 1980s, by the mid-1980s economists were once again turning
their attention to the problem of unemployment, in particular the rise in the
estimated NAIRU (see Bean et al., 1986; Fitoussi and Phelps, 1988; Summers,
1990; Layard et al., 1991, 1994; Bean, 1994; Cross, 1995; Nickell,
1997, 1998; Siebert, 1997; Katz and Krueger, 1999; Blanchard and Wolfers,
2000; Fitoussi et al., 2000; Hall, 2003).
While estimates of the NAIRU are obviously subject to uncertainty given
the broad range of determinants, recent OECD estimates shown in Table 7.1
indicate the much superior performance of the US economy compared to the
euro area and G7 countries.
During the late 1960s, Friedman and Phelps independently put forward
expectations-augmented models of the Phillips curve. In Friedman’s model
the market-clearing rate of unemployment is called the natural rate of unemployment
and is associated with a stable rate of inflation. As we noted in
Chapter 4, many economists (especially those sympathetic to Keynesianism)
prefer to use the ‘NAIRU’ concept (non-accelerating inflation rate of unemployment),
rather than ‘natural rate’ when discussing long-run unemployment.
The NAIRU terminology was first introduced by Modigliani and Papademos
Source: ‘Labour market performance and the OECD jobs strategy’, OECD, June 1999,
Figure 7.10 Standardized unemployment rates for North America (USA
and Canada) and OECD Europe, 1972–98
% 12
11
10
9
8
7
6
5
4
3
2
1
0
1972 74 76 78 80 82 84 86 88 90 92 94 96 98
North America
OECD Europe
Table 7.1 NAIRU estimates for the G7 countries and the euro area
Country/area 1980 1985 1990 1995 1999
Canada 8.9 10.1 9.0 8.8 7.7
France 5.8 6.5 9.3 10.3 9.5
Germany 3.3 4.4 5.3 6.7 6.9
Italy 6.8 7.8 9.1 10.0 10.4
Japan 1.9 2.7 2.2 2.9 4.0
UK 4.4 8.1 8.6 6.9 7.0
USA 6.1 5.6 5.4 5.3 5.2
Euro area 5.5 7.1 8.8 9.2 8.8
Source: ‘Revised OECD Measures of Structural Unemployment’, OECD, December 2000.
(1975) as ‘NIRU’ (non-inflationary rate of unemployment), defined as ‘a rate
such that, as long as unemployment is above it, inflation can be expected to
decline’. The NAIRU acronym was introduced by James Tobin (1980c) and
has since been used to describe estimates of the natural rate of unemployment
(see Cross et al., 1993; Cross, 1995). However, according to King (1999):
the natural rate of unemployment and the NAIRU are quite different concepts. The
former describes a real equilibrium determined by the structural characteristics of
the labour and product markets – the grinding out of Friedman’s Walrasian general
equilibrium system (modified, if necessary, by non-Walrasian features of
labour markets such as imperfect competition, search behaviour and efficiency
wages). It exists independently of the inflation rate. In contrast, the latter, as well
as being affected by these structural characteristics, is also affected by the gradual
adjustment of the economy to past economic shocks that determine the path of
inflation. Because it is defined as the unemployment rate at which there is no
immediate pressure for a change in the inflation rate, it is a reduced form – not a
structural – variable.
Therefore, the NAIRU concept takes into account inertia in the system which
allows a protracted response of the economy to various economic shocks.
Another way to distinguish between these concepts relates to their
microfoundations. Friedman’s natural rate is a market-clearing concept,
whereas the NAIRU is that rate of unemployment which generates consistency
between the target real wage of workers and the feasible real wage
determined by labour productivity and the size of a firm’s mark-up. Since the
NAIRU is determined by the balance of power between workers and firms,
the microfoundations of the NAIRU relate to theories of imperfect competition
in the labour and product markets (see Carlin and Soskice, 1990; Layard
et al., 1991). However, while recognizing these differences between the concepts
of the natural rate and the NAIRU, Ball and Mankiw (2002) argue that
NAIRU is ‘approximately a synonym for the natural rate of unemployment’.
Therefore, in the discussion that follows we will assume that the two concepts
can be used interchangeably.
According to Friedman’s natural rate hypothesis, fluctuations of aggregate
demand cannot exercise any influence over the natural rate of unemployment,
which is determined by real supply-side influences. The conventional natural
rate view allows monetary and other demand shocks to shift aggregate demand,
thereby influencing the actual rate of unemployment in the short run.
But, as inflationary expectations adjust, unemployment returns to its long-run
equilibrium (natural) value. In new classical models, if the change in aggregate
demand is unanticipated, the combined effect of perfectly flexible prices
and rational expectations ensures that unemployment will quickly return to
its natural rate.
This conventional view is illustrated in Figure 7.11, where the natural rate
of unemployment (UN) is given by point A. Any decline in aggregate demand
will increase the actual rate of unemployment temporarily to point B, while
an expansion of aggregate demand will lower actual unemployment and will
Figure 7.11 The ‘natural rate’ view of the relationship between actual
unemployment and equilibrium unemployment
A
Expansionary demand shock O Contractionary demand shock
UN
B
C
Rising rate
of inflation
Falling rate
of inflation
Unemployment
move the economy temporarily to point C. However, in the long run, unemployment
returns to the natural rate of unemployment at point A.
The dramatic rise in unemployment rates, particularly in Europe during the
1980s, suggested that this conventional view of the natural rate of unemployment
(or NAIRU) must be wrong. It seems that the NAIRU must have risen,
and estimates made by econometricians, such as those presented in Table 7.1,
confirm this view. Several explanations have been put forward to explain
these higher levels of unemployment. One view explains it as a result of
specific policy changes that have reduced the flexibility of the labour market;
more powerful trade unions, higher unemployment compensation and longer
duration of benefits, minimum wage laws, excessive regulations, employment
protection, and higher taxation are, or have been, favourite candidates (see
Minford, 1991; Nickell, 1997; Siebert, 1997; Ljungquist and Sargent, 1998;
Fitoussi et al., 2000; Roed and Zhang, 2003). However, while some of these
factors may account for rising unemployment in the 1970s, many economists
do not believe that they offer a complete explanation of the unemployment
experienced in the 1980s and 1990s (union power, for example, has been
significantly reduced in the UK and has never been a major factor in the US
economy)
The simultaneous rise in the actual and equilibrium rates of unemployment
has led some new Keynesian economists to explore a second explanation
which allows aggregate demand to influence the natural rate (or NAIRU).
Models which embody the idea that the natural rate depends on the history of
the equilibrium rate are called ‘hysteresis’ theories. It was Phelps (1972) who
first suggested that the natural rate equilibrium will be partly influenced by
the path taken to reach equilibrium. Phelps called this path dependence
‘hysteresis’, a term borrowed from physics, where it is used to describe the
lagging of magnetic induction behind the source of magnetism (see Cross,
1995).
In hysteresis models the natural rate of unemployment will increase if the
actual rate of unemployment in the previous period exceeds the former time
period’s natural rate (Hargreaves-Heap, 1980). This can be expressed as
follows:
UNt = UNt−1 + a(Ut−1 −UNt−1) + bt (7.14)
In equation (7.14) UNt is the natural rate of unemployment at time t, UNt–1 is
the previous period’s natural rate of unemployment, Ut–1 is the previous
period’s actual rate of unemployment and bt captures other influences on the
natural rate such as unemployment compensation. If we assume bt = 0, then
equation (7.14) can be rearranged as (7.15):
UNt −UNt−1 = a(Ut−1 −UNt−1) (7.15)
From equation (7.15) it can be seen that UNt > UNt–1 if Ut–1 > UNt–1. In other
words, the shifting actual rate of unemployment acts like a magnet, pulling
the natural rate of unemployment in the same direction. Thus while it may be
reasonable to argue that aggregate demand does not affect UN in the short run,
it is likely that prolonged periods of abnormally high or low economic activity
will shift the natural rate of unemployment.
The impact of hysteresis is illustrated in Figure 7.12. The initial equilibrium
unemployment rate is represented by point A. If the economy is subject
to a negative aggregate demand shock, output falls and unemployment rises
to point B. When the economy recovers from recession, the unemployment
rate does not return to point A. Instead, because of hysteresis effects, the new
NAIRU is at point C. If the economy is now subject to a positive aggregate
demand shock, unemployment falls to point D. When the economy returns to
equilibrium the NAIRU has now fallen to point E. A further recession traces
out a path for this economy through points F to G. In other words, the
NAIRU is influenced by the actual rate of unemployment which itself is
determined mainly by aggregate demand.
Figure 7.12 The hysteresis view of a ‘time-varying’ NAIRU
A
Expansionary demand shock O Contractionary demand shock
B
C
Rising rate
of inflation
Falling rate
of inflation
Unemployment
F
E
G
D
Theories of hysteresis fall into two main categories, namely duration theories
and insider–outsider theories. Duration theories point out that, when Ut >
UNt, the problem of structural unemployment is exacerbated because the unemployed
suffer a depreciation of their human capital (skills) and as a result
become increasingly unemployable. A high rate of unemployment also tends to
generate an increasing number of long-term unemployed who exercise little
influence on wage bargaining, which also raises the NAIRU. Insider–outsider
theories emphasize the power of insiders which prevents the downward adjustment
of wages in the face of high unemployment. As a result, outsiders are
unable to price their way back into jobs following a rise in unemployment (see
Blanchard and Summers, 1986, 1988). If hysteresis effects are important, the
sacrifice ratio associated with disinflation and recessions is much greater than
is suggested by the original natural rate hypothesis, since high unemployment
will tend to persist (for an extended discussion of the issues raised in this
section, the reader is referred to Cross, 1988; Cross et al., 1993, Layard et al.,
1991; Blanchard and Katz, 1997; Gordon, 2003).
Another distinctive approach to explaining movements in the equilibrium
rate of unemployment over time has been developed by Edmund Phelps and
his co-researchers. In a series of books and papers Phelps has sought to
construct an endogenous theory of the natural rate of unemployment where
‘the equilibrium path of unemployment is driven by the natural rate that is a
variable of the system rather than a constant or a forcing function of time …
hence a moving-natural-rate theory holds the solution to the mystery of what
is behind the shifts and long swings of the unemployment rate’ (Phelps, 1994;
see also Fitoussi and Phelps, 1988; Phelps and Zoega, 1998; Phelps, 2000).
While in Friedman’s natural rate model equilibrium unemployment can change
due to supply-side influences, in Phelps’s dynamic intertemporal non-monetary
equilibrium model it is real demand shocks that are ‘the great movers
and shakers of the economy’s equilibrium path’, although real supply (energy)
shocks also play an important role. Phelps (1990, 1994) classifies his
approach to explaining unemployment as both ‘modern’ and ‘structuralist’,
although it does contain both neoclassical (the role of real interest rates
determined in the capital market), Austrian (the effect of the rate of interest
on the supply of output) and new Keynesian elements (asymmetric information
and efficiency wages). Phelps highlights the impact on the path of the
equilibrium unemployment rate of real influences such as technology, preferences,
social values and institutions. As Phelps (1994) recalls, by the 1980s
he had decided that any chance of accounting for the major swings in economic
activity since the war would require:
abandoning the simplification of a natural rate unemployment rate invariant to
non-monetary (not just monetary) macro shocks in favour of models making the
equilibrium rate an endogenous variable determined by a variety of non-monetary
forces … the longer booms and slumps … must be explained largely as
displacements of the equilibrium path of unemployment itself, not as deviations of
unemployment around an impervious equilibrium path.
In looking for the causes of what Fitoussi et al. (2000) call ‘the great slump’,
that is, the upward shift of equilibrium unemployment rates in the 1980s, the
chief suspects identified are five OECD-wide real shocks to business profitability
and worker’s incentives (see Phelps, 1994), namely:
1. reduced expectations of productivity growth, hence increased effective
cost of capital;
2. an increase in the expected real interest rate which also raises the effective
cost of capital;
3. an increase in services from workers private assets (see Phelps, 2000);
4. an increase in social entitlements relative to after-tax real wages resulting
from the 1970s productivity slowdown and expansion of the welfare
state;
In the Phelps (1994) model the main driving force behind the rise of the
NAIRU is the increase in real interest rates that occurred across the OECD
countries after the mid-1970s and on into the 1980s (Blanchard and Wolfers,
2000). The rise in world real interest rates, to a large extent induced by US
fiscal expansion in the early 1980s, lowered incentives to accumulate capital,
and, for a given real wage, led to a reduction of labour demand. The high real
interest rate which induced an appreciation of the US dollar (real depreciation
of European currencies) during this period also led to an increase in
European price mark-ups (firms do not lower their export prices in proportion
to the depreciation) and, in consequence, this led to a reduction in labour
demand and a rise in the equilibrium rate of unemployment. For example,
Phelps and Zoega (1998, p. 788) find a very strong correlation between the
world real rate of interest and UK unemployment for the period 1975–95.
Note that in contrast to real business cycle models, where changes in the real
interest rate influence the supply of labour through the intertemporal labour
substitution hypothesis, in Phelps’s model changes in the real interest affect
the demand for labour (for a critique see Madsen, 1998).
While the impact of real shocks as an explanation of increases in the broad
evolution of European unemployment is persuasive, Blanchard and Wolfers
(2000) argue that ‘there is insufficient heterogeneity in these shocks to explain
cross-country differences … Adverse shocks can potentially explain the
general increase in unemployment. Differences in institutions can potentially
explain differences in outcomes across countries.’ Therefore, a more convincing
story of the evolution of the NAIRU in Europe must involve the interaction
of observable real shocks combined with a recognition of the institutional
diversity present across European countries (see Nickell, 1997; and Layard
and Nickell, 1998).
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