Discussion Paper Details

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Title: Temporary Shocks and Unavoidable Transitions to a High-Unemployment Regime

Author(s): Wouter Den Haan

Publication Date: January 2003

Keyword(s): fiscal policy, matching model, multiple equilibria, sunspots, tax burden and unemployment benefits

Programme Area(s): International Macroeconomics

Abstract: This Paper develops a model with multiple steady states (low tax and low unemployment versus high tax and high unemployment) in which equilibrium selection is not conditioned on a sunspot variable. Instead, large temporary shocks initiate unavoidable transitions from one steady state to another. Tax policies have huge effects in some cases. In particular, it is possible that the transition to the high-unemployment steady state after a negative shock can be avoided if the government borrows to finance unemployment benefits, and in some cases it is even possible that a credible permanent tax cut would force the economy out of the high-unemployment steady state. The model is used to explain the high European unemployment rates in the 80?s and 90?s. The Paper argues that the increase in unemployment during the 70?s played a key role because it led to an increase in the obligation to pay unemployment benefits. The implied tax burden was so big that the transition to the high-unemployment regime was the unique equilibrium outcome.

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Bibliographic Reference

Den Haan, W. 2003. 'Temporary Shocks and Unavoidable Transitions to a High-Unemployment Regime'. London, Centre for Economic Policy Research.