Differences between the Natural Rate of Unemployment and the NAIRU

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The Natural Rate of Unemployment (NRU) is the equilibrium level of unemployment to which the economy tends, as defined by Milton Friedman's misperception model of labour markets. This model assumes that, in the long-run, labour markets clear (i.e. supply of and demand for labour are equal, that is, in equilibrium, at a single wage rate and level of employment). According to this hypothesis, unanticipated inflation can cause money illusion: workers will ask for low nominal wage increases and think that their real wages are rising when in fact the real wage rate is falling. The workers' misperception will cause them to increase their labour supply, whilst the actual fall in real wages will cause firms to increase their labour demand, causing an overall increase in employment and output.

Once the workers realise that inflation has occurred, they will adjust their expectations and nominal wage demands, and unemployment will return to the NRU (although at a new, higher expected rate of inflation). The actual level of the NRU itself is determined by the inherent characteristics of the labour market, such as any market imperfections or informational problems.

The NAIRU (Non-Accelerating Inflation Rate of Unemployment) hypothesis, on the other hand, is based on the New Keynesian imperfect competition model of labour markets. This model assumes that both labour and product markets are imperfectly competitive, due to trade unions and oligopolistic firms. Labour (through the process of collective bargaining) can therefore demand a bargained real wage (BRW), whilst firms can set a price-determined real wage (PRW) at which they can earn supernormal profits. The firms' PRW consists of the actual value of output (as determined by the marginal product of labour) minus a per worker profit for the firm.

In the NAIRU model, labour's BRW increases with the level of employment. This is because increased employment means that there are fewer unemployed workers looking for jobs, so labour markets become tighter and the bargaining power of labour increases. Unemployment disciplines the workforce. The PRW remains fixes at a set wage rate, on the other hand. This is because it represents the claims of firms on output per worker. The wage rate and level of employment at which the BRW and the PRW are equal is known as the NAIRU. This is the wage rate and level of employment at which the competing claims of labour (the workers) and capital (the firms) are satisfied.

The NAIRU model clearly has pseudo-Marxist overtones

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, especially the notion that wages and employment are determined by the competing claims of labour and capital rather than by the supply of and demand for labour. The Natural Rate of Unemployment model conversely assumes that labour markets can clear in the long-run. The experience of many OECD economies in the 1970s and 80s, during which time mass involuntary unemployment was witnessed, led to a backlash against the Natural Rate model. It was during this time that economists such as Bob Rowthorn began to flesh out the NAIRU model which has since come to prominence in macroeconomic circles.

Empirically, the existence and persistence of involuntary unemployment is the main difference between the NAIRU and the Natural Rate of Unemployment - at the Natural Rate of Unemployment, all unemployment must be voluntary, whereas at the NAIRU equilibrium, involuntary unemployment can persist.