Unemployment and Labour Markets

Lecture 7
Hysteresis
Pontus Rendahl
rpk22@cam.ac.uk
University of Cambridge

Michaelmas, 2011

Outline
Readings
Facts
US vs. European unemployment
Hysteresis
Three explanations
Insider-outsider theory
Long-term unemployment
Capital scrapping

Readings

I
I
I

These notes
Mankiw, Ch 6
Carlin and Soskice, Ch 19

Unemployment rate US vs. Europe

10

Europe

Unemployment Rate (%)

9
8
7

United States

6
5
4
3
2
1
0

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Year

Inflation rate US vs. Europe

12
11
10

Euro area

Inflation

8
7
6

US

5
4
3
2
1
0

1970

1975

1980

1985

1990

Year

1995

2000

2005

2010

Unemployment and Inflation in the US

Unemployment and Inflation

10
9

Unemployment

8
7
6
5
4
3
2

Inflation

1
0

1959

1970

1980

Year

1990

2000

2010

Unemployment and Inflation in Europe

12

Unemployment and Inflation

11

Unemployment

10
9
8
7
6
5
4
3
2

Inflation

1
0

1959

1970

1980

Year

1990

2000

2010

Patterns
I
I

What can we take away from these graphs

For the US:
I
I
I
I

Unemployment increased substantially during the 70s.

It took two big leaps
The second is associated with a sharp drop in inflation
Then inflation stabilized and unemployment reverted
back

Recall the Phillips-curve

t t1 = (ut un )

This is quite a successful NAIRU-story

Patterns

For Europe
I

I
I

I
I

Unemployment increase continuously throughout the 70s

and most of the 80s
Then it stabilized
Inflation fell dramatically during the late 70s and early
80s
Then it stabilized

Is this consistent with the NAIRU-theory?

Yes. But only if weve seen a sharp increase in the natural
rate of unemployment

US vs. European unemployment

I
I

This means that in order to understand the patterns of

inflation and unemployment in Europe, we need to
understand why the natural rate of unemployment
appears to have changed.
Lets consider two different hypothesis
1, Labour market institutions have increase rigidities in
European labour markets
2, Oil price shocks have contributed to the increase in
unemployment

Union density in Europe

Union density (percent of workers)

55
50
45
40

Italy

35
UK
Germany

30
25
20
15

France

10
5
0

1970

1975

1980

1985

Year

1990

1995

2000

2005

Historical oil prices

140

Oil price (200$/bbl)

120
100
80
60
40
20
0

1969

1975

1980

1985

1990

Year

1995

2000

2005

2010

Unionization and Oil prices

I

While unionization did increase on average from

1970-1980, it has decreased ever since
Oil prices did ramp up substantially in 1973-74 and
1979-80, and unemployment appears to have been
affected
However, oil prices fell in the 80s and remained quite low
until 2005
So none of these are likely explanations for the patterns
we see (although we will return to this question in the
next lecture)

Hysteresis

I
I
I
I

Instead, we will focus on another idea: hysteresis

Hysteresis refers to path dependence
Alternative words are inertia or simply persistence
The main idea is that one-time event may have very long
lasting effects
And how long lasting (or how much hysteresis) depends
on labour market institutions

Hysteresis

Three explanations for Hysteresis

I Insider-outsider theory
I Long-term unemployment
I Capital scrapping

Insider-Outsider theory of hysteresis

I

Generally attributed to Lindbeck and Snower (1986), and

Blanchard and Summers (1986)
The idea is the following
I

The labour market is characterized by insiders (those

who have jobs) and outsiders (those who dont)
Insiders have tremendous bargaining power over
employers due to their possession of firm-specific human
capital
In addition, insiders care only about two things: 1,
Keeping their jobs, and 2, Given (1) maximize their real
wages
They pay no attention whatsoever to outsiders desire to
find a job

Nominal wage, W

Insider-Outsider Model

P/(1+)

Demand

U
PeF(u,z)

Unemployment, U

Nominal wage, W

Positive demand shock

P'/(1+)

Demand

Demand

U
PeF(u,z)

Unemployment, U

Insider-Outsider theory of hysteresis

I
I

What happens here?

In the standard aggregate supply model, an increase in
demand is like an increase in prices
Normally, this would lead to lower real wages, and lower
unemployment
Now, however, the insiders dont care about lower
unemployment, but bargain up wages immediately
As a consequence, the increase in demand as no effect on
unemployment
Lets look at a fall in demand which is subsequently
reverted back to normal

Nominal wage, W

Original equilibrium

P/(1+)

Demand

U
PeF(u,z)

Unemployment, U

Nominal wage, W

Negative demand shock

P/(1+)

Demand
Demand

PeF(u,z)

Unemployment, U

Nominal wage, W

New bargaining curve

P/(1+)

Demand
Demand

PeF(u,z)

Unemployment, U

Nominal wage, W

Reversion of shock

P(1+)

Demand
Demand

PeF(u,z)

Unemployment, U

Insider-Outsider theory of hysteresis

The negative demand shocks has initially the same effect

as in the aggregate supply model
Wage cuts dont happen easily, so unemployment
increases
When demand reverts back, insiders immediately demand
higher wages, and unemployment remains the same
Thus, the initial increase in unemployment will persist
indefinitely. Sometimes this is called pure hysteresis

Long-term unemployment
I

The second explanation of hysteresis refers to long-term

unemployment
In particular, we think of the unemployment pool divided
into two distinct groups; the long-term unemployed and
the short-term unemployed
The long-term unemployed can be more accurately
thought of as being out-of-the-labour-force, although
they are counted as inside the labour force
Then a worker which has just been matched with a firm
does not fear long-term unemployment, almost by
definition
Consider now a temporary negative demand shock which
is subsequently reverted

Wage, w

Original situation

P/(1+)

Demand

U
PeF(u,z)

Unemployment, U

Wage, w

Negative demand shock

P/(1+)

Demand

Demand
PeF(u,z)

Unemployment, U

Long-term unemployment

I
I

So far everything is the same as the aggregate demand

model
Unemployment increase as real wages increases
Suppose now, however, that the entire increase in
unemployment was of a long-term nature
This implies that bargaining P e F (u, z) only depends on
the short-term unemployment, which is unchanged!

Wage, w

Change in bargaining

P/(1+)

Demand

Demand
PeF(u,z)

Unemployment, U

Wage, w

Reversion of demand

P/(1+)

Demand

Demand
PeF(u,z)

Unemployment, U

Long-term unemployment
I

Thus, as the entire increase in unemployment was of a

long-term nature, and bargaining depends on short term
unemployment, the bargaining curve shifts outward
When demand is restored, unemployment does not revert
back as the composition of unemployment has changed
Normally, we wouldnt think of the entire increase in
unemployment as of a long-term nature, but only parts of
it
In that situation, unemployment would partially revert
back when demand is restored, but not fully
So this is not a model of pure hysteresis

Capital scrapping
I

The third explanation underpinning a very persistent

increase in the natural rate of unemployment concerns
capital scrapping
The idea is the following:
I

A fall in demand, may lead firms to scrap capital (or at

least not invest)
A lower level of capital lower the marginal product of
labour, and lowers labour demand
We can think about this as (k), the markup, depends
negatively on k
So less k means higher prices given wages, or simply
lower real wages

So lets consider the demand and then story again

Wage, w

Original equilibrium

P/(1+(k))

Demand

U
PeF(u,z)

Unemployment, U

Wage, w

Fall in demand

P/(1+(k))

Demand

Demand

Unemployment, U

PeF(u,z)

Wage, w

Capital scrapping

P/(1+(k))

Demand

Demand

Unemployment, U

PeF(u,z)

Wage, w

Reversion of demand

P/(1+(k))

Demand

Demand

PeF(u,z)

Unemployment, U