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

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  • Karanassou, Marika
  • Snower, Dennis J

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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Suggested Citation

  • Karanassou, Marika & Snower, Dennis J, 1998. "How Labour Market Flexibility Affects Unemployment: Long-Term Implications of the Chain Reaction Theory," Economic Journal, Royal Economic Society, vol. 108(448), pages 832-849, May.
  • Handle: RePEc:ecj:econjl:v:108:y:1998:i:448:p:832-49
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    References listed on IDEAS

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    1. Michael F. Bryan & Stephen G. Cecchetti, 1993. "The consumer price index as a measure of inflation," Economic Review, Federal Reserve Bank of Cleveland, issue Q IV, pages 15-24.
    2. Michael F. Bryan & Stephen G. Cecchetti & Rodney L. Wiggins, 1997. "Efficient inflation estimation," Working Paper 9707, Federal Reserve Bank of Cleveland.
    3. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, January.
    4. Artis, M.J. & Kontolemis, Z.G., 1998. "Inflation Targeting and the European Central Bank," Economics Working Papers eco98/4, European University Institute.
    5. International Monetary Fund, 1998. "The United Kingdom's Experience with Inflation Targeting," IMF Working Papers 98/87, International Monetary Fund.
    6. Goodhart, Charles A E, 1994. "What Should Central Banks Do? What Should Be Their Macroeconomic Objectives and Operations?," Economic Journal, Royal Economic Society, vol. 104(427), pages 1424-1436, November.
    7. Michael Woodford, 1994. "Nonstandard Indicators for Monetary Policy: Can Their Usefulness Be Judged from Forecasting Regressions?," NBER Chapters,in: Monetary Policy, pages 95-115 National Bureau of Economic Research, Inc.
    8. Walsh, Carl E, 1995. "Optimal Contracts for Central Bankers," American Economic Review, American Economic Association, vol. 85(1), pages 150-167, March.
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    11. repec:sae:niesru:v:164:y::i:1:p:65-79 is not listed on IDEAS
    12. Freeman, Donald G., 1998. "Do core inflation measures help forecast inflation?," Economics Letters, Elsevier, vol. 58(2), pages 143-147, February.
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    More about this item

    JEL classification:

    • J21 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Labor Force and Employment, Size, and Structure
    • J23 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Labor Demand
    • J31 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Wage Level and Structure; Wage Differentials
    • J64 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Unemployment: Models, Duration, Incidence, and Job Search
    • J68 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Public Policy

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