Hysteresis and the natural rate of unemployment in Ireland

Conventional Keynesian or Classical macroeconomic theories must be considered\ninadequate to explain unemployment experiences such as the Irish\none. Rigidities that one might associate with fixed contracts, or even\nadjustment costs in relation to prices or quantities, can hardly account\nfor 17 years of rising unemployment. Indeed, surely such an upturn in\nconjunction with the apparent breakdown of the unemployment-inflation\nrelationship serves to challenge the existence in Ireland of a stable "natural"\nrate of unemployment towards which the economy would gravitate\nand at which the level of inflation would remain constant.\nWithin this context it is compelling to consider the existence of hysteresis\nin the labour market - i.e. the possibility that an increase in umemployment\ncould have a direct impact on the natural rate or, to put it another way,\nthat this year's equilibrium unemployment depends upon last year's actual\nrate.\nThis paper examines the presence of hysteresis in the Irish labour market\nand in so doing enables estimates for the Irish natural rate of unemployment\nto be calculated. In all cases the long-term equilibrium rate of\nunemployment is considered to be the same as the natural rate.\nIn Section 2 competing explanations for the hysteresis phenomenon, specifically physical capital, human capital and insider (union members)-outsider\n(non-union members) explanations are discussed. The following section\nbriefly considers some econometric issues which may arise in the presence\nof hysteresis while Section 4 is concerned with some discrete time dynamics\nassociated with the natural rate of unemployment. In Section 5\na procedure for testing for hysteresis is derived from the analysis in the\npreceding two sections. The paper then goes on to apply this test to Irish\ndata and discusses the implications of the results. Since no such work\nhas been done in an international context, it was not possible to compare\nthe Irish outcome with that for other economies. In so far as possible\nmathematical considerations are dealt with in the appendices.