Wage Formation and the (Non-)Existence of the NAIRU

The influence of NAIRU theory on economic policy is both puzzling and unfortunate, especially in a European context. This paper shows that standard rationality assumptions and objective functions may fail to generate a well-defined NAIRU in a unionized economy. It then presents two simple models with endogenous wage aspirations. One version of the model produces a unique long-run NAIRU while the other implies the presence of aspiration-induced hysteresis in the employment rate. The hysteretic version seems preferable on theoretical grounds and--at a stylized level--this version also fits the empirical evidence better than the non-hysteretic version. The argument implies that an expansionary aggregate demand policy combined with temporary incomes policies may reduce European unemployment permanently without adverse inflationary consequences