Vicious and Virtuous Circles: The Political Economy of Unemployment

We develop a theoretical nonlinear model of equilibrium unemployment and test its policy implications for a number of OECD countries. The theory here sees the natural rate and the associated equilibrium path of unemployment as endogenous, pushed by the interaction of shocks and the institutional structure of the economy; the channel through which these two forces feed on each other is a political economy process whereby voters with limited information on the natural rate of unemployment react to shocks by demanding more or less social protection. The reduced form results from a dozen OECD economies give support to the model and further evidence is obtained by structural estimates for the UK.