Hysteresis in Unemployment: Evidence from 48 U.S. States

By Song, Frank M.; Wu, Yangru | Economic Inquiry, April 1997 | Go to article overview

Hysteresis in Unemployment: Evidence from 48 U.S. States


Song, Frank M., Wu, Yangru, Economic Inquiry


I. INTRODUCTION

One central idea in macroeconomics is the equilibrium unemployment rate hypothesis.(1) In many macroeconomic models which allow for some degree of price stickiness, fluctuations in demand and supply may lead to deviations of the actual unemployment rate from its equilibrium value; these deviations in turn trigger changes in the inflation rate.

There is nothing in the equilibrium unemployment rate literature which even vaguely suggests such a rate is constant. Indeed, many studies have analyzed the factors which cause the equilibrium unemployment rate to change over time or across areas. For example, Summers [1986] presents evidence of an increased "normal" U.S. unemployment rate since the mid-1960s and argues that this increase has in large part resulted from high and growing noncompetitive wage differentials. Barro [1988] addresses the issue of persistence of unemployment in various countries over a number of time periods and relates measures of persistence to variables that matter theoretically for the economy's speed of adjustment. Blanchard and Summers [1986; 1987] propose the so-called hysteresis hypothesis of unemployment. Hysteresis is the term used to describe the long-lasting influence of history on the natural rate. A recession potentially has permanent effects if it changes attitudes and/or characteristics of the unemployed, and particularly the long-term unemployed. Furthermore, the latter may exert less pressure on the wage setting because they will become "outsiders" in the labor market. The insiders (union members or currently employed workers) have much incentive to keep wages from falling.(2)

The hysteresis hypothesis of unemployment has important policy implications. It suggests that high unemployment, if left by itself, may persist and continue to be a serious problem in the economy even in the long run. This possibility leaves more room for active government policies to fight recessions and manage the economy.

The fact that the actual unemployment rate may not fluctuate around some "natural" rate suggests the possibility of nonstationarity in the unemployment series. This relationship can be illustrated with a simple model from Wyplosz [1987] or Brunello [1990]. Consider the following Phillips curve:

(1) [Mathematical Expression Omitted]

where

[P.sub.t] is the current inflation rate;

[E.sub.t-i][P.sub.t], is the expected inflation rate of time t, given information at time (t-1);

[u.sub.t] is the current unemployment rate;

[Mathematical Expression Omitted] is the natural unemployment rate;

[Beta] is the slope of the Phillips curve; and

[[Xi].sub.t] is an error term.

The possibility of hysteresis arises when the natural rate is a function of past unemployment rates. This can be expressed as follows:

(2) [Mathematical Expression Omitted]

where c and [Alpha] are constants and [[Zeta].sub.t] is an error term. Substituting (2) into (1) yields

(3) [u.sub.t] = c + [Alpha] [u.sub.t-1] + [[Epsilon].sub.t]

where

[[Epsilon].sub.t] = (1 / [Beta])([E.sub.t-1][P.sub.t]-[P.sub.t] + [[Xi].sub.t]) + [[Zeta].sub.t].

Hysteresis requires the parameter [Alpha] in (3) to be equal to one.(3) It implies that, once disturbed, the unemployment rate tends to wander around without returning to a mean value. In this case, the unemployment rate and also the natural rate contain a unit root. In contrast, when [Alpha] is between zero and one, the natural-rate evolves towards its steady-state level, c / (1 - [Alpha]), and the weak version of the natural-rate hypothesis holds. As long as [Alpha] is larger than zero, there is persistence in unemployment rate in the sense that past unemployment affects the natural rate. We, however, seek to test for the existence of hysteresis, the extreme version of persistence. Finally, when the parameter [Alpha] equals zero, the natural rate stays at a constant level, c. …

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