Causes of unemployment and the effectiveness of demand policies

The rise in unemployment suffered by many advanced economies since 2007, particularly in Europe, has revived long standing debates about what policies are better equipped to fight unemployment. In one side of the debate, we find those who believe that structural reforms, particularly in the labour market, are the only way to achieve long lasting reductions of unemployment. In the other side of the controversy, we find those who argue that macroeconomic stimuli ought to be used to tackle unemployment. European policy makers have predominantly favoured the first view and accordingly they have agreed upon the “Europe 2020 agenda” (European Commission, 2010a) and most recently the “Fiscal Compact” (European Commission, 2012). The theoretical underpinning of these policies is the NAIRU model proposed by Layard and Nickell (1986). According to this approach the NAIRU is exclusively determined by structural features of the labour and goods market, which cannot be modified by demand policies. Further, the NAIRU is also thought to acts as an anchor for economic activity. Consequently, the only policy that can achieve long lasting reductions of unemployment is one that tackles the features of the labour and goods market that determine the NAIRU. This characterization of the NAIRU is far from uncontroversial, and many economists argue that there are long run links between aggregate demand and unemployment, which can channel the effects of demand policies onto the NAIRU. A well-known example is the hysteresis hypothesis proposed by Blanchard and Summers (1986), although Sawyer (1982), Rowthorn (1995,1999) and Hein (2006) also propose other channels. Furthermore, some of these authors also question the anchor properties of the NAIRU. Thus far, empirical research has not been able to settle this controversy. The aim of this thesis is to provide a new empirical assessment of the determinants of the NAIRU and its anchor properties. For that purpose, we analyse data from eight EU economies, namely the United Kingdom, the Netherlands, Germany, France, Italy, Spain, Denmark and Finland. The data cover the period from 1980 to 2007. We employ time series techniques, more specifically the Cointegrated Vector Autoregressive (CVAR) approach. This is applied to a theoretical model that encompasses the conflicting views of the NAIRU that we aim to assess. The key novelty of our research is the use of this encompassing model. This is the first time that such an approach has been employed in the literature. The second novelty of our work is that our sample extends the analysis to the 2000s, a period which has rarely been studied before. The findings presented in this thesis are in contrast to the dominant NAIRU view proposed by Layard and Nickell. First, we find that in all the countries in our sample, the NAIRU is determined by at least one of the following variables: Productivity, long term unemployment, capital stock or long term real interest rates. Second, we find that in all the countries in our sample, the NAIRU is either a weak anchor for economic activity or has no anchor properties at all.