Testing for Hysteresis in Unemployment An Unobserved Components Approach

Abstract

We suggest a new test for hysteresis in unemployment based on an unobserved components model. Observed unemployment rates are decomposed into a natural rate component and a cyclical component. The impact of lagged cyclical shocks on the current natural component is the measure of hysteresis. To identify the two components of unemployment, we assume that the cyclical compoentn is correlated with capacity utilization. The model is applied to U.S. and German data. We find no evidence of hysteresis in U.S. data. German unemployment rates exhibit substantial hysteresis. A shock of 1.0 percent to the current cyclical component permanently increases future German natural rates by about 0.5 percent. For both countries, natural rate shocks turn out to be an important impulse mechanism to explain movements in observed unemployment rates.

We would like to thank Ben Bernanke, John Campbell, Whitney Newey, Pierre Perron, Mark Schankerman, and two anonymous referees for helpful comments. All remaining errors are our own. The first author acknowledges financial support by the Erwin Schroedinger Foundation and the second author by the Australian Treasury. The views expressed herein are our own and should not be attributed to the sponsoring bodies.