DP3618 Vicious and Virtuous Circles - The Political Economy of Unemployment
We develop a theoretical nonlinear model of equilibrium unemployment and test its policy implications for a number of OECD countries. The theory here sees the natural rate and the associated equilibrium path of unemployment as endogenous, pushed by the interaction of shocks (mainly demand-management in nature) 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 react to shocks by demanding more or less social protection. The results from a dozen OECD economies appear to confirm a pattern of unemployment behaviour in which unemployment moves with nonlinear dynamics between high and low equilibria in response to shocks obtained. The policy conclusion is that macroeconomics and supply side policies are intimately linked through political economy and these have the capacity to create both ?vicious? and ?virtuous? circles of economic performance.