Unemployment in a Small Open Economy: Finland and New Zealand

Abstract

Unemployment is now the key issue for economic policy in the OECD and Europe in particular. By examining data from the period 1962-1996 for two highly different small open OECD economies, Finland and New Zealand, in a VEC model this paper seeks to cast light on three questions: the degree to which unemployment has been the result of slow adjustment to large external shocks; the degree to which differences in labour market structures can lead to different responses to shocks; the importance of the exchange rate and the external sector in resolving the problem. The approach uses a fairly general model of the labour market that includes wages, unemployment, the capital stock and the terms of trade. It uses cointegration analysis to establish long-run relationships among the four variables. In the case of Finland we find that the short-run response of unemployment to shocks (to the long-run relationship) is large relative to the response of real wage and the terms of trade. In New Zealand on the other hand both real wages and the terms of trade, in particular, adjust more rapidly. As a result the burden of short-run adjustment in the New Zealand economy appears to fall more heavily on (relative) prices. Since the unemployment rate in both countries displays hysteresis, these results suggest that relative price adjustment in the New Zealand economy is more effective in preventing adverse aggregate shocks from becoming adverse unemployment shock.