Hysteresis Us Germ

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    em pec (1990) 1 5 :18 5-19 8

    T e s t i n g f o r H y s t e r e s i s i n U n e m p l o y m e n tA n U n o b s e rv e d C o m p o n e n t s A p p r o a c h 1B y A . J a e g e r 2 a nd M . P a r k i n s o n 3

    Abstract: W e s ugges t a new tes t fo r hys te res i s in unem ploym en t bas ed on an unobs erved com po-nents m ode l . Obs erved une m plo ym e n t r a tes a r e decom pos ed in to a na tu ra l r a te com pone n t and acyc l ica l com p onen t . T he im pac t o f l agged cyc l ica l s hocks on the cu r ren t na tu ra l com pon en t i s them eas ure o f hys te resi s . T o iden t i fy the two com ponen ts o f unem ploym en t , we as s um e tha t the cyc-l i cal com poen tn i s co r re la ted w i th capa c i ty u t i li za t ion . T he m od e l i s app l ied to U . S . and Germ and a t a . W e f i n d n o e v i d e n c e o f h y s t e r e s i s i n U . S . d a t a . G e r m a n u n e m p l o y m e n t r a t e s e x h i b i ts ubs tan t ia l hys te res i s . A s hock o f 1 . 0 pe rcen t to the cu r ren t cy c l ica l com ponen t pe rm an en t ly in -c reas es fu tu re Germ an na tu ra l r a tes by abou t 0 . 5 pe rcen t . Fo r bo th cou n t r i es , na tu ra l r a te s hocksturn ou t to be an im por tan t im pu ls e m ech an is m to exp la in m ovem en ts in obs erved unem ploym en trates.

    1 I n t r o d u c t i o n

    O v e r th e l a s t 15 y e a rs , h i g h a n d p e r s i s t e n t u n e m p l o y m e n t h a s s u r f a c e d a s t h e m a j o rm a c r o e c o n o m i c p r o b l e m i n m a n y E u r o p e a n e c o n o m i e s ( in p a r t i c u l a r i n G e r m a n y ,F r a n c e , I t a ly a n d th e U n i t e d K i n g d o m ) a s w e l l a s i n A u s t r a l i a a n d C a n a d a . I nc o n t r a s t , th e U . S . h a s e x p e r i e n c e d l a r g e s w i n g s i n it s u n e m p l o y m e n t r a te w i t h a na p p a r e n t t e n d e n c y o f o b s e r v e d u n e m p l o y m e n t t o m o v e b a c k t o w a r d s o m e r e l a t i v e l ys t ab l e u n d e r l y i n g r a t e . B y w a y o f f u r t h e r c o n t r as t , J a p a n a n d s o m e E u r o p e a n e c o -n o m i e s , n o t a b l y A u s t r i a , N o r w a y , S w e d e n , a n d S w i t z e r l a n d , h a v e e n j o y e d b a s i -c a l l y s t a b le u n e m p l o y m e n t r a te s o v e r t h e s a m e t i m e p e r i o d . E x p l a i n i n g t h i s d iv e r -

    1 W e w o u l d l i k e to t h a n k B e n B e r n a n k e, J o h n C a m p b e l l , W h i t n e y N e w e y , P i e r r e P e r ro n , M a r kSchankerm an , and two anonym ous r e fe rees fo r he lp fu l com m ents . A l l r em ain ing e r ro r s a r e ou rown . T he f i r s t au tho r acknow ledges f inanc ia l s uppor t by the E rwin Sc hroed inger Founda t ion andthe s econd au thor by the Aus t r a l i an T reas u ry . T he v iew s expres s ed here in a re ou r own and s ho u ldno t be a t t r ibu ted to the s pons or ing bod ies .2 A lber t J aeger, In s t i tu te fo r Advan ced S tud ies , S tum pergas s e 56 , A-106 0 Vienna , Aus t r i a .3 Mar t in Park inson , Depar tm e n t o f E conom ics , P r ince ton Univer s i ty , P r ince ton , NJ 08540 , USA ,and Aus t r a l i an T reas u ry , Canber ra , AC T 2600 , Aus t r a l i a .

    0377-7332 /90 /2 /185-198 $2 . 50 9 1990 Phys ica -Ver lag Heide lberg

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    186 A. Jaeg er and M. Parkinson

    s it y o f e x p e r i e n c e h a s p u t m a c r o e c o n o m i c t h e o r y t o a s e v e r e t es t, a n d s e v e r a l c o m -m e n t a t o r s h a v e a l r e a d y e x p r e s s e d d o u b t t h a t it h as m e t t h is c h a l l e n g e a d e q u a t e l y(see B l inde r 1988) .As a ma t te r o f t axono m y, s t anda rd theor ies o f unem ploy m ent sugges t tha t h ighobse rv ed unem ploy m ent can be the re su l t o f st ructu ral fac to rs tha t have changed thena tu ra l ra te o f unem ploy m ent o r o f cyc l i ca l fac to rs tha t have t empora r i ly d r iven un-employment above the na tu ra l ra te . The re la t ive ly low and s t ab le in f l a t ion ra te s o ft h e 1 9 8 0 s a r e w i d e l y i n t e r p r e te d a s c a s ti n g d o u b t o n t h e p o s s i b i l it y t h a t c y c l i c a lfac to rs a re re spon s ib le fo r h igh un em ploy m ent ra te s . The p res s ing ques t ion then i s:W h y h a v e n a t u ra l r a t es m o v e d u p s o s h ar p l y i n m a n y c o u n t r i e s o v e r th e la s t 1 5yea rs?

    A c c o r d i n g t o o n e i n f l u e n t i a l v i e w , u n e m p l o y m e n t i n c r e a s e d b e c a u s e t h es t ruc tu ra l de te rminan t s o f the na tu ra l ra te changed . B runo and S achs (1985 ) a rguet h a t i n c r e a s e d , , w a g e g a p s " l e d t o u p w a r d p r e s s u r e o n t h e n a t u r a l r a t e i n m a n yc o u n t r i e s d u r i n g t h e 1 9 7 0 s. L a y a r d a n d N i c k e l l ( 1 9 8 6 ) r e p o r t t h a t p a rt o f t h e i n-c rease in Br it i sh u nem ploy m ent can b e t raced to changes in s t ruc tu ra l fac to rs inc lu -d i ng u n e m p l o y m e n t b e n e f i ts , e m p l o y m e n t p r o t e c ti o n l a w s , a n d u n i o n m i li ta n c y .L ind bec k (1985 ) a t t r ibu te s the inc rease in na tu ra l ra te s to the deb i li t a ting e f fe c t s o fi n c r e a s ed g o v e r n m e n t i n t er v e n ti o n . C o e ( 1 9 8 9 ) i n v e s t ig a t e s L i n d b e c k ' s h y p o t h e s i sf o r C a n a d a a n d c o n c l u d e s t h at t h e in c r e a s e d g e n e r o s i t y o f th e u n e m p l o y m e n t i n -su rance sys tem w as a m a jo r cause fo r the r is e in the na tu ral ra te dur ing the 1970s .

    T h e m a i n a l t e r n a ti v e h y p o t h e s i s t o t h e s tr u c tu r a l v i e w i s b a s e d o n t h e c o n c e p to f hys te re s i s in the na tu ra l ra te . F i r s t app l i ed in unam bigu ous t e rms to the l abormarke t by Hargreaves Heap (1980) , th i s hypo thes i s pos tu la te s tha t the na tu ra l ra ted e p e n d s o n t h e p r ev i o u s h i st o r y o f u n e m p l o y m e n t . T h r e e m a j o r m e c h a n i s m s f o rt hi s h i s to r y d e p e n d e n c e h a v e b e e n s u g g e s t e d - t h e e r o s io n o f h u m a n c a p i ta l d u e t ou n e m p l o y m e n t , a s h o r t a g e o f p h y s i c a l c a p it a l, a n d s o c a l le d , , in s i d e r - o u ts i d e r "me chan i sms a s soc ia ted wi th and so ca l l ed , , ind ide r -ou t s ide r" m echan i sms a s soc ia -t e d w i t h w a g e d e t e r m i n a t i o n . B l a n c h a r d a n d S u m m e r s ( 1 9 8 6 ) a n d G o r d o n ( 1 9 8 8 )f ind tha t the hys te re s i s hypo thes i s i s we l l suppo r ted fo r s eve ra l European coun t r i e sb y e m p i r i c a l e v i d e n c e f r o m w a g e - p r i c e s y s t e m s . S o m e s u p p o r t in g e v i d e n c e i s a ls or e p o r t e d b y F r a n z ( 1 9 8 7 ) f o r G e r m a n y a n d G r e g o r y ( 1 9 8 6 ) f o r A u s t r a l i a . C o e(1987) repor t s mixed re su l t s in a s tudy o f wage equa t ions fo r 12 OEC D coun t r ie s .

    I n t hi s p a p e r w e a d o p t a n u n o b s e r v e d c o m p o n e n t s (UC) a p p r o a c h t o t e st f o rh y s t e re s i s i n u n e m p l o y m e n t . U n o b s e r v e d c o m p o n e n t s m o d e l s h a v e b e e n s u g g e s t e db y W a t s o n a n d E n g l e ( 1 9 8 3 ) a n d H a r v e y a n d T o d d ( 1 9 8 3 ) a s f le x i b l e i n s tr u m e n t sf o r e x t r a c t i n g i n f o r m a t i o n f r o m o b s e r v e d v a r i a b l e s ( e . g . t h e u n e m p l o y m e n t r a t e )r e g a rd i n g t h e p ro p e r t i e s o f u n o b s e r v a b l e v a r i a b l e s ( e. g. t h e n at u r al u n e m p l o y m e n tra te ) . Our app l i ca t ion o f UCm o d e l s t o l a b o r m a r k e t s i s c l o s e ly r e la t e d t o w o r k b yCla rk (198 9) . The bas ic idea in s t a ti s ti ca l t e rms i s to d i s en tang le the nons ta t iona ryn a tu r al r a t e c o m p o n e n t a n d t h e s t a ti o n a ry c y c l i ca l c o m p o n e n t o f u n e m p l o y m e n t b yus ing the in fo rma t ion con ta ined in a va r iab le tha t i s co r re la ted wi th the cyc l i ca l

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    Testing for Hysteresis in Unemployment 187

    component of unemployment. Preferably, the variable used to achieve the decom-position should be stationary to obviate the need to decompose this variable itselfinto a stationary and nonstationary part. For this reason, we use capacity utilizationto identify the decomposition. Other variables such as Gross National Productcould be used for the decomposition. The difficulty with GNP, however, is that itis itself nonstationary and has first to be decomposed into a stationary and nonsta-tionary component. Regardless of the variable used to achieve the decomposition ofunemployment into its natural and cyclical components, the measure of hysteresisdefined in this paper is given by the impact on the current natural rate of lagged cyc-lical shocks.

    We use the UC approach to provide informat