From Short to Medium Run (IS-LM-PC)

Hysteresis in Unemployment

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Hysteresis: persistent recessions raise the natural rate un itself, making damage long-lasting. Channels — (1) skill depreciation of long-term unemployed; (2) insider-outsider bargaining; (3) stigma from long spells. Implies conventional demand policy can have permanent effects on un — justifying aggressive stabilisation.

Derivation

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The Standard View (No Hysteresis)

u_n = (m + z)/\alpha

Natural rate is structural. Demand shocks cause temporary deviations; $u$ eventually returns to $u_n$ .

The Hysteresis Challenge

u_n^t = u_n^0 + \lambda \sum_{k=1}^{K} u_{t-k}

Natural rate depends on past unemployment. Persistent recessions raise $u_n$ itself.

Three Channels

The hysteresis mechanism is not one thing but three reinforcing processes:

Skill depreciation. Long unemployment spells erode human capital.
Insider-outsider bargaining (Blanchard-Summers 1986). Employed workers negotiate wages without regard for the unemployed.
Stigma. Employers use long unemployment duration as a negative productivity signal.

European Experience

| Year | EU un | |------|-------| | 1975 | ~3% | | 1985 | ~10% | | 1995 | ~10% | | 2005 | ~8% |

EU unemployment ratcheted up after 1970s oil shocks and 1980s recessions — never fully recovered. US unemployment, in contrast, mean-reverts much faster.

Policy Implications

Before recession: avoid letting recessions deepen — hysteresis makes downturns permanent.
After recession: aggressive demand stimulus, even if overshooting inflation target, pays off by preventing un drift.
Labour-market policy: active labour-market programmes (training, job-search support) reduce hysteresis.

This underpins the "run hot" policy approach (Yellen 2017, ECB 2020s) — tolerating above-target inflation to keep $u$ low.

Worked Example

Full-hysteresis model: un_t = u_{t−1}. Start at un_0 = 5%. Recession pushes u to 8% for 2 years, then demand recovers.

Year 1: u = 8%, un = 5%.
Year 2: un_1 = u_0 = 5%. u = 8%.
Year 3: un_2 = u_1 = 8%. Demand recovers, u = un_2 = 8%.
Permanent un rise of 3 pp from a 2-year recession. Demand policy to avoid the initial rise would have saved the entire increase.

Full hysteresis: 2-year recession permanently raises un by 3 pp. Implies strong preventive-stabilisation rationale.

Common Mistakes

—Assuming un is always structural and immune to cyclical shocks — hysteresis rejects this.
—Confusing hysteresis with the standard natural-rate model — they differ on persistence of shocks.
—Ignoring policy implications: under hysteresis, demand stabilisation has long-run value.
—Treating all forms of unemployment as equally damaging — long-term spells are disproportionately harmful.

Exam Cues

→Hysteresis: persistent recessions raise un itself.
→Three channels: skill depreciation, insider-outsider bargaining, stigma.
→European vs US: EU shows hysteresis, US mean-reverts faster.
→Policy implication: aggressive demand stabilisation justified if hysteresis is present.