Does the interaction between shocks and institutions solve the OECD shocks and institutions solve the OECD Unemployment Puzzle ? A Theoritical and Empirical Appraisal

This paper provides a theoretical and empirical appraisal of the shocks-institutions controversy as an explanation of unemployment heterogeneity in OECD countries. Since the influential work of Blanchard and Wolfers (2000), many studies have tried to explain the differences in the OECD unemployment rate as the result of interaction between shocks and labour market institutions. Modelling this interaction is viewed as a promising way for understanding the puzzle of unemployment disparities which can be explained by none of the two kinds of variables individually. Indeed, on the one hand, OECD countries have been affected by symmetric shocks and have nevertheless experienced different unemployment dynamics. On the other hand, before the 1970s, all these countries had low unemployment rates in spite of quite different labour market institutions. Using cross section data, these studies test a direct relationship between the unemployment rate, shocks and institutions and thus have the advantage of readily allowing for international comparisons. However, testing a reduced equation of the unemployment rate constitutes also their main drawback as they do not analyze formally the link between the unemployment rate and the wage determination process. As a consequence, empirical results are quite divergent among studies since they often lay on ad hoc specifications that may have little theoretical foundations.