1. On the relevance of equilibrium unemployment and aggregate demand – some thoughts
Steinar Holden
Department of Economics
Summer course, JVI, Vienna, 2005

2. Outline The macroeconomics of equilibrium unemployment theory
Norway from 1980
Changes in eq. unemployment, or
Persistent effect of aggregate demand?
Equilibrating mechanisms
Experiences from other selected countries
Reflections and thoughts

3. Equilibrium unemployment Price curve
Un U
Real wage
Wage curve
Equilibrium unemployment
Price curve
Shocks may take U away from Un.
If U < Un, increased wage and price growth will push U towards Un.

4. Persistent fluctuations in unemployment
Under equilibrium unemployment theory, fluctuations are caused by expectational errors and nominal rigidities
Unlikely that these will persist for many years
=>Persistent fluctuations usually viewed as due to changes in Un
But is this always the correct interpretation?
Other sources of fluctuations are plausible
Equilibrating mechanisms are weak

5. Norway, from 1980 to 2004
Liberalization of credit markets and expansionary fiscal policy lead to boom in
Huge imbalance was created, with over-investment and high household debt
Then the economy turned,
investment fell sharply
Households had to reduce consumption
oil prices fell and
fiscal policy had to be tightened
The start of a long-lasting downturn

6. Persistent fluctuations in investment, saving and unemployment, Norway

7. Unemployment & investment/GDP, Norway, deviation from mean

8. Persistent increase in unemployment
Sluggish demand or increased equilibrium unemployment?
Increased eq unemployment consistent with OECD’s NAWRU-estimate (Non-Accelerating Wage Rate of Unemployment)
Constructed to be the rate of unemployment for which wage growth is constant
But can this explain what happened?

9. Unemployment (U) and NAWRU-estimates for the Nordic countries (from Holden og Nymoen, SJE, 2002)

10. Difference between actual and eq
Difference between actual and eq. unempl (U – NAWRU) (horisontally) as predictor of the change in wage growth (vertically) (Holden og Nymoen, SJE, 2002)

11. Changes in equilibrium unemployment unlikely explanation
NAWRU-estimates poor predictive power
At the same time no changes in labour market institutions that could explain the increase in equilibrium unemployment
More complete wage equation indicated stable wage setting (Holden&Nymoen)

12. Alternative explanation – persistent deviation from equilibrium unemployment
Fluctuations caused by real shocks, related to consumption, investment and fiscal policy
The equilibrating mechanisms are weak, and cannot be expected to restore equilibrium quickly

13. How powerful are the equilibrating mechanisms ? (I)
Forward-looking elements
Consumption smoothing – but what do households know about the future?
If income falls, what happens to consumption?
transitory shock ? => C falls less
persistent shock ? => C falls in proportion
persistent shock to the growth rate ? => C falls more
Likewise for investment – firms may postpone investments if significant risk that demand remains sluggish
If large shocks affects the expected future path, the effect on consumption and investment can be large

14. How powerful are the equilibrating mechanisms ? (II)
Wage and price growth
Pigou-effect is negligible
Usually strong effect of tight labour market
Dampening effect of slack labour market is often weaker
Lower (zero) bound to nominal wage growth
Euro-zone: rigidities + country-spec shock
Weak expansionary effect of lower wage and price growth
Income distribution effect opposite direction

15. How powerful are the equilibrating mechanisms ? (III)
International competitiveness
Important, but traded sector only part of overall economy
Low relative costs may be viewed as temporary
Available resources
Do high unemployment really stimulate investment and job creation?
Monetary policy potentially important equilibrating mechanism
But Norway had fixed exchange rate target at the time

16. Equilibrating mechanisms – summing up
Equilibrating mechanisms in the economy are not strong
probably stronger down (if activity too high) than up (if activity is too low)
Negative, large or persistent shocks may have persistent effects on unemployment
Most fluctuations probably due to transitory shocks => economy will return when shock vanishes
Investment ↓=> GDP↓ ;Investment ↑=> GDP ↑
But some shocks are permanent
Large shocks may affect expected future path of the economy

17. Is Norway unique ?
No, in fact very similar development in other Nordic countries, and also other European countries
Finland and Sweden experienced very similar consumption and investment fluctuations as Norway
But also important differences
Norway had oil money, and could pursue expansionary fiscal policy without concern for high future public debt
In Finland, the downturn was strengthened by the breakdown of the Soviet Union, which was an important export market

18. Persistent effect of downturn in Finland in the early 1990s

19. Unemployment & investment/GDP, Finland, deviation from mean

20. Persistent effect of downturn in Sweden, too

21. Unemployment & investment/GDP, Sweden, deviation from mean

22. And the UK

23. Unemployment & investment/GDP, the UK, deviation from mean

24. And in Euro 12

25. Unemployment & investment/GDP, Euro area, deviation from mean

26. Long-lasting effect on employment rates (15-64): Finland and Sweden

27. And in Norway, the UK and the Euro Area

28. Tentative conclusions (in the wait for better evidence)
Long-lasting fluctuations in investment, saving and unemployment
Clear indication of a role for aggregate demand
Changes in structural variables in the labour market (wage setting, labour market institutions, benefits, etc) cannot by themselves explain these correlated fluctuations
Explanations based on the combination of shocks and institutions more promising
But these explanations allow role of demand