chapter  7
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Labor market dynamics in the Euro-area: A model-based sensitivity analysis

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The literature relating movements in unemployment and activity distinguishes between three main hypotheses. The first-the natural rate hypothesis-states that, although output-gap fluctuations generate cyclical movements in unemployment, in the long run, unemployment reverts back to equilibrium. This equilibrium is determined by deep, structural factors such as taxation, work incentives, unionization, social preferences etc. The second hypothesis-Hysteresis-suggests that unemployment has no such equilibrium-reversion properties: due to institutional and labor market rigidities, cyclical fluctuations can have permanent effects on the level of unemployment. There are two coexisting approaches to this hypothesis, one simply implying that unemployment is characterized as a nonstationary unit-root process. The other one emphasizes the possible nonlinearity involved in the formation of the equilibrium unemployment, the complexity of which is not simply captured by a unit-root process.1 In the former case, the unemployment follows a random walk, reflecting all types of shocks cumulated over history; in the latter, unemployment may be affected solely by shocks of large magnitude, moreover in an asymmetric way

Focusing on the statistical aspects of the issue, a number of studies have examined unemployment persistence among OECD countries: for example, Arestis and Mariscal (1999), Bianchi and Zoega (1998), Brunello (1990) Jaeger and Parkinson (1994), Song and Wu (1997). Results are, however, often mixed. Broadly one might say that in many cases, the unit-root case cannot be rejected; however, when unemployment is examined in a multicountry panel context or where there is some control for structural breaks, a unit root is more often rejected. Accordingly some consensus seems to appear on the empirical validity of the so-called partial Hysteresis assumption-Layard et al. (1991)— that is, heavily persistent but equilibrium-reverting unemployment, albeit with slow speed of adjustment.2