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

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 labor market shocks and a network of lagged adjustment processes). We show that, for labor 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 U.K. 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 U.K. long-run equilibrium unemployment rate and for the movement of U.K. unemployment over the past 15 years.

JEL Classification: J21, J23, J31, J64, J68

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