1. On the relevance of equilibrium unemployment and aggregate demand – some thoughts
Steinar Holden
Department of Economics
December 2009
Based on Summer course, JVI, Vienna, 2005

2. Persistent fluctuations in unemployment
Under equilibrium unemployment theory, fluctuations are caused by expectational errors and nominal rigidities
Unlikely that these will persist for many years
=>Persistent fluctuations usually viewed as due to changes in eq. unemployment
But is this always the correct interpretation?
Other sources of fluctuations are plausible
Equilibrating mechanisms are weak

3. How powerful are the equilibrating mechanisms ? (I)
Forward-looking elements
Consumption smoothing – but what do households know about the future?
If income falls, what happens to consumption?
transitory shock ? => C falls less
persistent shock ? => C falls in proportion
persistent shock to the growth rate ? => C falls more
Likewise for investment – firms may postpone investments if significant risk that demand remains sluggish
If large shocks affects the expected future path, the effect on consumption and investment can be large

4. How powerful are the equilibrating mechanisms ? (II)
Wage and price growth
Pigou-effect is negligible
Usually strong effect of tight labour market
Dampening effect of slack labour market is often weaker
Lower (zero) bound to nominal wage growth
Weak expansionary effect of lower wage and price growth
Income distribution effect opposite direction

5. How powerful are the equilibrating mechanisms ? (III)
International competitiveness
Important, but traded sector only part of overall economy
Low relative costs may be viewed as temporary
Idle resources
Do high unemployment really stimulate investment and job creation?
Monetary policy potentially important
That is exactly Ball’s point
Fiscal policy potentially important
Depends on long run sustainability

6. Equilibrating mechanisms – summing up
Equilibrating mechanisms in the economy are not strong
probably stronger down (if activity too high) than up (if activity is too low)
Negative, large or persistent shocks may have persistent effects on unemployment
Most fluctuations probably due to transitory shocks => economy will return when shock vanishes
Investment ↓=> GDP↓ ;Investment ↑=> GDP ↑
But some shocks are permanent
Large shocks may affect expected future path of the economy

7. Norway, from 1980 to 2004
Liberalization of credit markets and expansionary fiscal policy lead to boom in
Huge imbalance was created, with over-investment and high household debt
Then the economy turned,
investment fell sharply
Households had to reduce consumption
oil prices fell and
fiscal policy had to be tightened
The start of a long-lasting downturn

8. Persistent fluctuations in investment, saving and unemployment, Norway

9. Unemployment & investment/GDP, Norway, deviation from mean

10. Is Norway unique ?
No, in fact very similar development in other Nordic countries, and also other European countries
Finland and Sweden experienced very similar consumption and investment fluctuations as Norway
But also important differences
Norway had oil money, and could pursue expansionary fiscal policy without concern for high future public debt
In Finland, the downturn was strengthened by the breakdown of the Soviet Union, which was an important export market

11. Persistent effect of downturn in Finland in the early 1990s

12. Unemployment & investment/GDP, Finland, deviation from mean

13. Persistent effect of downturn in Sweden, too

14. Unemployment & investment/GDP, Sweden, deviation from mean

15. And the UK

16. Unemployment & investment/GDP, the UK, deviation from mean

17. And in Euro 12

18. Unemployment & investment/GDP, Euro area, deviation from mean

19. Tentative conclusions (in the wait for better evidence)
Long-lasting fluctuations in investment, saving and unemployment
Indication of a role for aggregate demand
Changes in structural variables in the labour market (wage setting, labour market institutions, benefits, etc) cannot by themselves explain these correlated fluctuations
Explanations based on the combination of shocks and institutions more promising
But these explanations allow role of demand