ABSTRACT
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
