How Natural Is the Natural Rate of Unemployment in Europe?
European economic performance has been disappointing in the 1980s. High unemployment has been a dominant policy issue, but in order to react properly, government authorities had to determine the causes of this unemployment. If inadequate aggregate demand were the source, expansionary fiscal or monetary policy could help to solve the problem; on the other hand, if movements in labor supply were to blame, traditional macro policy would be ineffective. European officials clearly leaned toward the labor supply explanation, as aggregate deman policy remained conservative throughout the decade.
The predominant empirical literature in the mid-1980s seemed to prescribe this conservative approach. This article updates these studies. Using their methodology, the author shows that labor supply movements alone cannot explain the unemployment that occurred over most of the decade. An alternative approach suggests one possible answer, that the formation in 1979 of the European Monetary System unexpectedly tightened macroeconomic policy throughout Europe.