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Temporary Shocks and Unavoidable Transitions to a High-Unemployment Regime

  • Den Haan, Wouter

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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3704.

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Date of creation: Jan 2003
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Handle: RePEc:cpr:ceprdp:3704
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  1. Lindbeck, A, 1996. "The West European Employment Problem," Papers 616, Stockholm - International Economic Studies.
  2. Steve Nickell & Jan van Ours, 2000. "The Netherlands and the United Kingdom: a European unemployment miracle?," Economic Policy, CEPR;CES;MSH, vol. 15(30), pages 135-180, 04.
  3. Francesco Daveri & Guido Tabellini, 2000. "Unemployment, growth and taxation in industrial countries," Economic Policy, CEPR;CES;MSH, vol. 15(30), pages 47-104, 04.
  4. Christian Haefke, 2001. "Shocks and institutions in a job matching model," Economics Working Papers 568, Department of Economics and Business, Universitat Pompeu Fabra, revised Aug 2001.
  5. Marimon, Ramon & Zilibotti, Fabrizio, 1999. "Unemployment vs. Mismatch of Talents: Reconsidering Unemployment Benefits," Economic Journal, Royal Economic Society, vol. 109(455), pages 266-91, April.
  6. Bryant, John, 1983. "A Simple Rational Expectations Keynes-Type Model," The Quarterly Journal of Economics, MIT Press, vol. 98(3), pages 525-28, August.
  7. Lars Ljungqvist & Thomas J. Sargent, 1998. "The European Unemployment Dilemma," Journal of Political Economy, University of Chicago Press, vol. 106(3), pages 514-550, June.
  8. Alfonso Novales & Jesús Ruiz, 2001. "Dynamic Laffer Curves," Documentos de Trabajo del ICAE 0106, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico.
  9. den Haan, Wouter J. & Ramey, Garey & Watson, Joel, 2003. "Liquidity flows and fragility of business enterprises," Journal of Monetary Economics, Elsevier, vol. 50(6), pages 1215-1241, September.
  10. Olivier J. Blanchard & Lawrence H. Summers, 1986. "Fiscal Increasing Returns, Hysteresis, Real Wages and Unemployment," Working papers 429, Massachusetts Institute of Technology (MIT), Department of Economics.
  11. Garey Ramey & Wouter J. den Haan & Joel Watson, 2000. "Job Destruction and Propagation of Shocks," American Economic Review, American Economic Association, vol. 90(3), pages 482-498, June.
  12. Marimon, R. & Zilibotti, F., 1998. "Unemployment vs. Mismatch of Talents," Papers 661, Stockholm - International Economic Studies.
  13. Mortensen, Dale T & Pissarides, Christopher A, 1999. "Unemployment Responses to 'Skill-Biased' Technology Shocks: The Role of Labour Market Policy," Economic Journal, Royal Economic Society, vol. 109(455), pages 242-65, April.
  14. Roger E. A. Farmer, 1997. "Money in a real business cycle model," Proceedings, Federal Reserve Bank of Cleveland, issue Nov, pages 568-623.
  15. Cooper, R. & Corbae, D., 1997. "Financial Fragility and the Great Depression," Working Papers 97-08, University of Iowa, Department of Economics.
  16. Wouter J. den Haan & Garey Ramey & Joel Watson, 1999. "Job Destruction and the Experiences of Displaced Workers," NBER Working Papers 7218, National Bureau of Economic Research, Inc.
  17. Schiantarelli, Fabio & Perotti, Roberto & Ardagna, Silvia & Alesina, Alberto, 2002. "Fiscal Policy, Profits, and Investment," Scholarly Articles 4685103, Harvard University Department of Economics.
  18. Mortensen, Dale T & Pissarides, Christopher A, 1994. "Job Creation and Job Destruction in the Theory of Unemployment," Review of Economic Studies, Wiley Blackwell, vol. 61(3), pages 397-415, July.
  19. Stephen Morris & Hyun Song Shin, 2000. "Rethinking Multiple Equilibria in Macroeconomic Modelling," Cowles Foundation Discussion Papers 1260, Cowles Foundation for Research in Economics, Yale University.
  20. Bassetto, Marco, 2005. "Equilibrium and government commitment," Journal of Economic Theory, Elsevier, vol. 124(1), pages 79-105, September.
  21. Nickell, Stephen & Layard, Richard, 1999. "Labor market institutions and economic performance," Handbook of Labor Economics, in: O. Ashenfelter & D. Card (ed.), Handbook of Labor Economics, edition 1, volume 3, chapter 46, pages 3029-3084 Elsevier.
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