Author/Editor:

Gabriel Di Bella ; Francesco Grigoli

Publication Date:

July 24, 2018

Electronic Access:

Free Full Text. Use the free Adobe Acrobat Reader to view this PDF file

Summary:

Despite conventional macroeconomic theory is based on the idea that demand shocks can only have temporary eects on unemployment, several European economies display highly persistent unemployment dynamics. The theory of hysteresis challenges this view and points out that, under certain conditions, demand disturbances can have permanent eects. In this paper, we nd strong empirical evidence of unemployment hysteresis in advanced economies since the 1990s. Relying on an identication scheme instigated by an insider/outsider model, we study the eects of demand shocks allowing for cross-country heterogeneous dynamics, and exploit such heterogeneity to investigate what institutional settings have the potential to soften or amplify the eects of demand shocks. Our results indicate that strengthening labor market institutions that promote a faster adjustment of real wages, removing disincentives for rms to hire and for workers to be employed, and improving the matching between labor supply and labor demand can lessen the eects of adverse demand shocks and lead to a faster reversion of unemployment rates to pre-shock levels.