Unemployment Surges in the EU: The Role of Risk Premium Shocks

Abstract

In the last decade, over half of the EU countries in the euro area or with currenciespegged to the euro were hit by large risk premium shocks. Previous papers havefocused on the impact of these shocks on demand. This paper, by contrast, focuses onthe impact on supply. We show that risk premium shocks reduce the output level thatmaximizes profit. They also lead to unemployment surges, as firms are forced to cutcosts when financing becomes expensive or is no longer available. As a result, allcountries with risk premium shocks saw unemployment surge, even as euro area corecountries managed to contain unemployment as firms hoarded labor during thedownturn. Most striking, wage bills in euro area crisis countries and the Balticsdeclined even faster than GDP, whereas in core euro area countries wage sharesactually increased.

Keywords: Risk premium, Market interest rates, Interest rates, Real interest rates, Unemployment, Risk premia, Euro area crisis, global economic and fincanial crisis, premia, euro area, pre-crisis, Baltics, GDP decline

JEL Classification: C53, E23, E27, E32, E63, E62, E01, G21, E52, J3