Hysteresis (economics)

If the unemployment rate exhibits hysteresis, then it follows a statistically non-stationary process, because the expected value of the unemployment rate now and in the future permanently shifts when the rate itself changes. The process with hysteresis is a unit root process, which in its simplest form can be characterized as U_t = U_{t-1} + e_t, where U_t is the unemployment rate at time t and e_t is a stationary error term representing outside shocks to the rate. According to this characterization, E_{t-1}(U_{t+\tau}) = U_{t-1} for all \tau = 0, 1, \ldots, where E_{t-1} refers to an expectation conditional on values observed no later than time t–1; any temporary shock to unemployment, represented by a single non-zero value of e_t, results in a permanent change to expected unemployment (even for \tau indefinitely large so the expectation is for indefinitely far into the future). A more elaborate model would allow E_{t-1}(U_{t+\tau}) to go up positively but less than one-for-one with e_t. In contrast, a non-hysteresis model of unemployment would have U_t following a stationary process, so that E_{t-1}(U_{t+\tau}) for arbitrarily large \tau would always equal a permanently fixed natural rate of unemployment. ==Causes==

When some negative shock reduces employment in a company or industry, there are fewer employed workers left. As the employed workers usually have the power to influence or set wages, their reduced number incentivizes them to bargain for even higher wages when the economy again gets better, instead of letting the wage stay at the equilibrium wage level, where the supply and demand of workers would match. This causes hysteresis, i.e., the unemployment becomes permanently higher after negative shocks. ==Policy implications==

If there is no hysteresis in unemployment, then for example if the central bank wishes to lower the inflation rate it may shift to a contractionary monetary policy, which if not fully anticipated and believed will temporarily increase the unemployment rate; if the contractionary policy persists, the unemployment rise will eventually disappear as the unemployment rate returns to the natural rate. Then the cost of the anti-inflation policy will have been temporary unemployment. But if there is hysteresis, the unemployment rise initiated by the contractionary policy will never completely go away, and in this case the cost of the anti-inflation policy will have been permanently higher unemployment, making the policy less likely to have greater benefits than costs. ==Evidence==

The European Central Bank has found strong empirical support for hysteresis in labour markets. Using OECD data for 29 countries from 2002 to 2019, the ECB found that shocks to unemployment permanently raise the non-accelerating inflation rate of unemployment (NAIRU), implying that demand-driven fluctuations can have enduring effects on labour market equilibrium. A study by the Federal Reserve Board using US data from 1983 to 2019 similarly identify permanent demand shocks that durably lower output, employment and investment, so far as to explaining more than half of long-run output fluctuations. The experience of the United Kingdom since the early 1980s counts against hysteresis as a determinant of the natural rate of unemployment, as unemployment fell much faster in the recovery from the early 1990s recession than after the early 1980s recession. An econometric study of fourteen OECD countries rejected the hysteresis hypothesis, as did a study at the state level in the US. ==See also==