Discussion Paper Details

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Title: How Labour Market Flexibility Affects Unemployment: Long-Term Implications of the Chain Reaction Theory

Author(s): Marika Karanassou and Dennis J. Snower

Publication Date: February 1998

Keyword(s): Employment, Labour Market Dynamics, Labour-Force Participation, Unemployment and Wage Setting

Programme Area(s): Human Resources

Abstract: This paper evaluates two theories of unemployment: the natural rate theory (whereby unemployment is depicted as fluctuating around a reasonably stable natural rate) and the chain reaction theory (which views movements in unemployment as the outcome of the interplay between labour market shocks and a network of lagged adjustment processes). We show that, for labour market systems with two common characteristics ? lagged endogenous variables and growing exogenous variables ? lags affect unemployment not only in the short run, but in the long run as well. The reason is that, in the presence of growing exogenous variables, the lagged responses are never able to work themselves out entirely. In this respect, the chain reaction theory contrasts sharply with the natural theory, which commonly views unemployment as approaching a natural rate determined solely by the values of the exogenous variables. The policy implications of the two theories are quite different as well. For an empirical model of the UK market, we show that unemployment does not converge to the natural rate, as conventionally defined. Furthermore, we show that lagged adjustment processes account for a substantial part of the UK long-run equilibrium unemployment rate and for the movement of UK unemployment over the past 15 years.

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Bibliographic Reference

Karanassou, M and Snower, D. 1998. 'How Labour Market Flexibility Affects Unemployment: Long-Term Implications of the Chain Reaction Theory'. London, Centre for Economic Policy Research.