Inflation and the NAIRU: assessing the role of long-term unemployment as a cause of hysteresis

Abstract

Hysteresis is receiving renewed interest and empirical support but the mechanisms behind it need better understanding. As a novel contribution to such understanding we empirically assess the interpretation according to which long-term unemployment causes hysteresis by increasing the NAIRU. We analyse a panel of 25 OECD countries over a long time span along two lines of enquiry. First, we verify whether long-term unemployment is ‘reversible’. Second, we focus on episodes of strong long-term unemployment reduction to check for inflationary effects in the subsequent years. We find a strong association between total and long-term unemployment rates even in upswings, testifying to macroeconomic reversibility. We do not find accelerating or persistently higher inflation after episodes of strong decline in long-term unemployment, even when the economy is estimated to be above its potential. Our results cast doubt on this explanation of hysteresis and challenge the notion of NAIRU as an inflationary barrier.