A New Explanation for European Unemployment Based on Rational Institutions

ZEI, University of Bonn Working Paper No. B9 2000

34 Pages Posted: 15 Jun 2001

See all articles by Robert MacCulloch

Robert MacCulloch

Imperial College London - Tanaka Business School

Rafael Di Tella

Harvard Business School - Business, Government and the International Economy Unit; National Bureau of Economic Research (NBER)

Date Written: February 25, 2001

Abstract

We show that European-style hysteresis can arise in a normative model where labor market institutions are determined optimally. We focus on the government's decision to set unemployment benefits in response to an unemployment shock. The government balances insurance considerations with the tax burden of benefits and the possibility that they introduce adverse "incentive effects" whereby benefits increase the unemployment rate. It is found that when the shock occurs, benefits should be increased in those economies where the adverse incentive effects of benefits are largest. Adjustment costs of changing benefits can introduce hysteresis in benefit setting and unemployment. A good temporary shock can permanently reduce unemployment by making it optimal to have a cut in unemployment benefits. Desirable features of the model are that we obtain an asymmetry out of a symmetric environment and that the mechanism yielding hysteresis is both simple (requires the third derivative of the utility function to be non-negative) and self-correcting.

Keywords: Optimal unemployment benefits, hysteresis, natural rate of unemployment

JEL Classification: J6

Suggested Citation

MacCulloch, Robert and Di Tella, Rafael, A New Explanation for European Unemployment Based on Rational Institutions (February 25, 2001). ZEI, University of Bonn Working Paper No. B9 2000. Available at SSRN: https://ssrn.com/abstract=273172 or http://dx.doi.org/10.2139/ssrn.273172

Robert MacCulloch (Contact Author)

Imperial College London - Tanaka Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

Rafael Di Tella

Harvard Business School - Business, Government and the International Economy Unit ( email )

Cambridge, MA
United States
617-495-5048 (Phone)
617-496-5985 (Fax)

HOME PAGE: http://www.people.hbs.edu/rditella/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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