Tuesday 28 December 2010

We all know about hysteresis in unemployment, which basically tells us that the equilibrium rate of unemployment rate depends on current and past unemployment rates. This problem becomes more severe as the duration of unemployment duration increases

In the picture below, one can observe how the unemployment rate and real GDP growth have evolved since 1986 (when Portugal joined the European Union). Unemployment persistence is obvious and it is also obvious that unemployment tends to increase/decrease when the growth rate is below/above 2%.

Using the data on the Picture, I estimate na AR(1) process for unemployment, with real GDP growth as an independent variable. I use this very simple model to make some projections for the evolution of the unemployment rate.

I consider three different scenarios. First, I admit that until 2015 Real GDP grows at 5.46%. This is the average real GDP growth rate in the first six years after joining the European Union. Let’s call this the dream scenario. Second, I will assume that real GDP growth is equal to the last six years average: 0.59%. This is the pessimistic scenario. Finally, I will consider a realistic, some may argue that is optimistic, scenario and assume that the growth rate will be the average since 1986: 2.64%. The results are described in the picture below.

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