Working Paper No. 153
Vincenzo Cassino and Richard Thornton
In this paper we examine the role played by various structural economic changes in explaining movements in the equilibrium rate of unemployment. We use the theoretical framework developed by Layard, Nickell and Jackman (LNJ) to explain changes in the equilibrium unemployment rate. In the LNJ framework, equilibrium unemployment is determined by the interaction of the price and wage-setting behaviour of firms and workers. The natural rate is a function of structural variables such as the replacement ratio and union power that affect the size of firms’ and workers’ mark-ups. Examining a wide range of equations with different combinations of structural variables, we find it extremely difficult to derive robust coefficient estimates that are statistically significant and have the expected signs on structural variables, unless a trended variable such as the owner-occupied housing rate is included. However, it is likely that these variables are simply capturing the upward trend in actual unemployment over most of the sample period in response to exogenous shocks. We find these results to be robust over different sample periods and different equation specifications. Therefore the results indicate that it is not possible to explain accurately movements in the natural rate using this approach, supporting the findings of other recent studies that suggest focusing on alternative less structural methods for estimating the equilibrium unemployment rate.