April 2004

IZA DP No. 1127: Unemployment, Growth and Fiscal Policy: New Insights on the Hysteresis Hypothesis

published in: Macroeconomic Dynamics, 2006, 10 (3), 285-316

We develop a growth model with unemployment due to imperfections in the labor market. In this model, wage inertia and balanced budget rules cause a complementarity between capital and employment capable of explaining the existence of multiple equilibrium paths. Hysteresis is viewed as the result of a selection between these different equilibrium paths. We use this model to argue that, in contrast to the US, those fiscal policies followed by most of the European countries after the shocks of the 1970's may have played a central role in generating hysteresis.