Hysteresis (economics)
Encyclopedia
In economics
, hysteresis refers to the possibility that periods of high unemployment
tend to increase the rate of unemployment below which inflation begins to accelerate, commonly referred to as the natural rate of unemployment
or non-accelerating inflation rate of unemployment (NAIRU
)). The term is based on the physical phenomenon of hysteresis
in magnetic
materials.
, because the expected value
of the unemployment rate now and in the future permanently shifts when the rate itself changes. The process with hysteresis is a unit root
process, which in its simplest form can be characterized as
where
is the unemployment rate at time t and 
is a stationary error term representing outside shocks to the rate. According to this characterization, 
for all 
, where 
refers to an expectation conditional on values observed no later than time t–1; any temporary shock to unemployment, represented by a single non-zero value of 
, results in a permanent change to expected unemployment (even for 
indefinitely large so the expectation is for indefinitely far into the future). A more elaborate model would allow 
to go up positively but less than one-for-one with 
. In contrast, a non-hysteresis model of unemployment would have 
following a stationary process, so that 
for arbitrarily large 
would always equal a permanently fixed natural rate of unemployment.
have the power to set wages, their reduced number incentivizes them to bargain for even higher wages when the economy again gets better, instead of letting the wage be at the equilibrium wage
level, where the supply and demand of workers would match. This causes hysteresis, i.e., the unemployment becomes permanently higher after negative shocks.
It has also been argued that unemployed people lose their skills during unemployment, which makes them less likely to again get jobs.
wishes to lower the inflation rate
it may shift to a contractionary monetary policy
, which if not fully anticipated and believed will temporarily increase the unemployment rate; if the contractionary policy persists, the unemployment rise will eventually disappear as the unemployment rate returns to the natural rate. Then the cost of the anti-inflation policy will have been temporary unemployment. But if there is hysteresis, the unemployment rise initiated by the contractionary policy will never completely go away, and in this case the cost of the anti-inflation policy will have been permanently higher unemployment, making the policy less likely to have greater benefits than costs.
An econometric study of fourteen OECD countries rejected the hysteresis hypothesis, as did a study at the state level in the US.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, hysteresis refers to the possibility that periods of high unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...
tend to increase the rate of unemployment below which inflation begins to accelerate, commonly referred to as the natural rate of unemployment
Natural rate of unemployment
The natural rate of unemployment is a concept of economic activity developed in particular by Milton Friedman and Edmund Phelps in the 1960s, both recipients of the Nobel prize in economics...
or non-accelerating inflation rate of unemployment (NAIRU
NAIRU
In monetarist economics, particularly the work of Milton Friedman, on which also worked Lucas Papademos and Franco Modigliani in 1975,NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment, and refers to a level of unemployment below which inflation rises.It is widely used in...
)). The term is based on the physical phenomenon of hysteresis
Hysteresis
Hysteresis is the dependence of a system not just on its current environment but also on its past. This dependence arises because the system can be in more than one internal state. To predict its future evolution, either its internal state or its history must be known. If a given input alternately...
in magnetic
Magnetism
Magnetism is a property of materials that respond at an atomic or subatomic level to an applied magnetic field. Ferromagnetism is the strongest and most familiar type of magnetism. It is responsible for the behavior of permanent magnets, which produce their own persistent magnetic fields, as well...
materials.
Implication for statistical characterization of unemployment
If the unemployment rate exhibits hysteresis, then it follows a statistically non-stationary processStationary process
In the mathematical sciences, a stationary process is a stochastic process whose joint probability distribution does not change when shifted in time or space...
, because the expected value
Expected value
In probability theory, the expected value of a random variable is the weighted average of all possible values that this random variable can take on...
of the unemployment rate now and in the future permanently shifts when the rate itself changes. The process with hysteresis is a unit root
Unit root
In time series models in econometrics , a unit root is a feature of processes that evolve through time that can cause problems in statistical inference if it is not adequately dealt with....
process, which in its simplest form can be characterized as
where
is the unemployment rate at time t and is a stationary error term representing outside shocks to the rate. According to this characterization, for all , where refers to an expectation conditional on values observed no later than time t–1; any temporary shock to unemployment, represented by a single non-zero value of , results in a permanent change to expected unemployment (even for indefinitely large so the expectation is for indefinitely far into the future). A more elaborate model would allow to go up positively but less than one-for-one with . In contrast, a non-hysteresis model of unemployment would have following a stationary process, so that for arbitrarily large would always equal a permanently fixed natural rate of unemployment.Causes
When some negative shock reduces employment in a company or industry, there are less employed workers left. As usually the employed workersInsider-outsider theory of employment
In labor economics, the insider-outsider theory examines the behavior of economic agents in markets where some participants have more privileged positions than others. The theory was developed by Assar Lindbeck and Dennis Snower....
have the power to set wages, their reduced number incentivizes them to bargain for even higher wages when the economy again gets better, instead of letting the wage be at the equilibrium wage
Equilibrium wage
In economics, the equilibrium wage is the wage rate that produces neither an excess supply of workers nor an excess demand for workers and labor market. See economic equilibrium....
level, where the supply and demand of workers would match. This causes hysteresis, i.e., the unemployment becomes permanently higher after negative shocks.
It has also been argued that unemployed people lose their skills during unemployment, which makes them less likely to again get jobs.
Policy implications
If there is no hysteresis in unemployment, then for example if the central bankCentral bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
wishes to lower the inflation rate
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
it may shift to a contractionary monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
, which if not fully anticipated and believed will temporarily increase the unemployment rate; if the contractionary policy persists, the unemployment rise will eventually disappear as the unemployment rate returns to the natural rate. Then the cost of the anti-inflation policy will have been temporary unemployment. But if there is hysteresis, the unemployment rise initiated by the contractionary policy will never completely go away, and in this case the cost of the anti-inflation policy will have been permanently higher unemployment, making the policy less likely to have greater benefits than costs.
Evidence
The experience of the United Kingdom since the early 1980s counts against hystersis as a determinant of the natural rate of unemployment, as unemployment fell much faster in the recovery from the early 1990s recession than after the early 1980s recession..An econometric study of fourteen OECD countries rejected the hysteresis hypothesis, as did a study at the state level in the US.