Abstract:
We develop an empirical nonlinear model of equilibrium unemployment and test its policy implications for a number of OECD countries. The model here sees the natural rate and the associated equilibrium
path of unemployment as endogenous, pushed by the interaction of shocks and the institutional structure
of the economy; the channel through which these two forces feed on each other is a political economy
process whereby voters with 'limited information' on the natural rate of unemployment react to shocks
by demanding more or less social protection. The reduced form results from a dozen OECD economies
give support to the model prediction of a pattern of unemployment behaviour in which unemployment
moves between high and low equilibria in response to shocks and the model specification is superior in
forecasting performance out of sample to alternative models of 'generalised hysteresis'.
