Hysteresis and Unemployment: A Preliminary Investigation

Abstract

This chapter outlines an alternative approach to the explanation of equilibrium unemployment. Instead of ruling out nominal variables, or temporary shocks to real or nominal variables, aspects of the past profile of such variables are used to determine the equilibrium rate of unemployment. The analytical innovation is to introduce hysteresis into the processes underlying the determination of equilibrium unemployment. This is done by specifying that economic agents respond in a nonlinear way to shocks; and by respecting the heterogeneity of economic agents by allowing them to respond differently to aggregate shocks. The key implications are that the economic system displays remanence, in that the application and removal of a shock will not be accompanied by a return to the status quo ante; and that the equilibrium rate of unemployment contains a selective memory of past shocks, retaining only the nondominated - extremum values of the shocks experienced. This analysis of hysteresis produces some sharp contrasts with treatments of hysteresis effects elsewhere in the economics literature. In the "hysteresis as persistence" usage, shocks can produce only persistence in the deviations of actual unemployment from unperturbed or homeostatic natural rate equilibria; whereas the presence of hysteresis means that shocks can change unemployment equilibria.