Expectation‐Driven Cycles and the Changing Dynamics of Unemployment

• Published date: 01 October 2022
• Author: ANTONELLO D'AGOSTINO,CATERINA MENDICINO,FEDERICO PUGLISI
• Date: 01 October 2022
• DOI: http://doi.org/10.1111/jmcb.12922

DOI: 10.1111/jmcb.12922

ANTONELLO D’AGOSTINO

CATERINA MENDICINO

FEDERICO PUGLISI

Expectation-Driven Cycles and the Changing

Dynamics of Unemployment

This paper provides new evidenceon the role of expectations for the change

in unemployment dynamics over time. Weshow that unanticipated changes

in expectations display large and persistent effects on the unemployment

rate in the 2007–09 downturn, contributing to maintain unemployment high

well after the most recent recession. We also nd that the changes in the

autocorrelation of the unemployment rate and its correlation with ination

generated by unanticipated changes in unemployment expectations help to

rationalize the pattern observed in the data in the post-1990 recessions.

JEL codes: C32, E24, E32

Keywords: Unemployment Expectations, Ination dynamics,

Time-varying Vector Autoregression

T     been characterized by re-

markable changes in the dynamics of U.S. unemployment and ination. In particular,

several authors have highlighted that after the most recent recession the economy

experienced a longer duration of high unemployment rates (see, e.g., Coibion,

Gorodnichenko, and Koustas 2013) coupled with a decline in ination that was small

Weare grateful to Agnès Belaisch, Fabio Canova, Michele Lenza, Giorgio Primiceri, Rolf Strauch and

seminar participants at Université Libre de Bruxelles, the 2014 Computational Economics and Finance,

the 2014 Annual Congress of the EEA, the 2014 Conference on Advances in Applied Macro-Finance and

Forecasting, the 2014 Bank of Portugal Conference on Econometric Methods for Banking and Finance

and the 5th UECE Conference on Economic and Financial Adjustments for useful comments and sugges-

tions. A previous version of this paper circulated as “Expectation-Driven Cycles: Time-varyingEffects.”

This paper started when Antonello D’Agostino was an economist at the European Stability Mechanism

and Caterina Mendicino was a research economist at the Department of Economic Studies of the Banco

de Portugal. The opinions expressed in this paper are the sole responsibility of the authors and do not

necessarily reect the position of the Banco de Portugal and the Eurosystem.

A D’Ais at Rokos Capital Management (E-mail: antonello.dagostino@gmail.com

). C Mis at European Central Bank, Directorate General Research, Monetary Policy

Research (E-mail: caterina.mendicino1@ecb.europa.eu). F Pis at the Department of Eco-

nomics, Northwestern University (E-mail: federicopuglisi2022@u.northwestern.edu ).

Received December 9, 2014; and accepted in revised form September 28, 2020.

Journal of Money, Credit and Banking, Vol. 54, No. 7 (October 2022)

© 2022 The Ohio State University.

2174 :MONEY,CREDIT AND BANKING

in comparison with the large and persistent increase in unemployment (see, e.g.,

Borio and Filardo 2007, Stock and Watson 2010).

Figure 3 documents the differences in unemployment dynamics around episodes

of economic downturns. The pattern of unemployment across the ve most recent

recessions suggests that the pre-1990s recessions featured a sharp increase in unem-

ployment during the downturns and an immediate decline soon after the end of the

recession. Indeed, during the recession of the early 1980s, the unemployment rate in-

creased from slightly below 6% to about 7.6%, then started declining before the end

of the recession. In the 1981–82 recession, unemployment increased by more than

2 percentage points and reached values above 10%. However, 1 year after the end

of the recession, the rate returned to levels displayed in the prerecession period. In

contrast, in the most recent recessions, unemployment displays a very slow recovery

and a remarkable increase in its persistence. During the recession of the early 1990s

and early 2000s, the unemployment rate stayed high even after the end of the reces-

sion and took several quarters to rebound to prerecession levels. It doubled since the

beginning of the recession (dated in 2007 Q4) and reached about 9.8% by the end of

2009. After the end of the most recent recession, the unemployment rate continued

increasing, suggesting a lagging and persistent dynamic. This rising trend continued

well after the end of the recession and only rebounded in the beginning of 2010. The

recent pattern of U.S. unemployment has been compared by many researchers to the

1980s European experience of high and persistent unemployment as described by

Blanchard and Summers (1987) among others.

A variety of explanations have been proposed to rationalize the changes in ina-

tion and unemployment over the last decades. Structural changes in the economy and

improved monetary policy (Stock and Watson 2010), a attening of the slope of the

Phillips curve and downward wage rigidity (Ball and Mazumder 2011), globaliza-

tion (Borio and Filardo 2007), and better “anchored” ination expectations to central

bank targets (Gambetti and Galí 2009, IMF 2013) could have played a role. However,

recent papers argue that the traditional channels may have had a limited role in ex-

plaining changes in unemployment over the last decade. Contrary to the conventional

wisdom, Coibion, Gorodnichenko, and Koustas (2013) nd that nancial shocks and

wage stickiness do not contribute to the rising persistence of U.S. unemployment,

whereas monetary and scal policies explain only part of the developments in un-

employment during the most recent recession. Coibion and Gorodnichenko (2015)

conclude that changes in consumer expectations are able to explain the missing dis-

ination.1Their results suggest that more attention should be paid to expectations.

1. Coibion, Gorodnichenko, and Koustas (2013) test a wide range of economic, demographic, and

cultural factors that could have inuenced the dynamics of unemployment. They also nd that changes

in U.S. labor mobility and demographic factors predict a decline in the persistence of unemployment,

whereas the decline in “trust among Americans” has a statistically signicant, although limited, impact

on the persistence of unemployment. Coibion and Gorodnichenko (2015) consider three explanations of

the missing disination during the most recent recession in the context of the Phillips curve: changes in

the natural rate of unemployment, unusual wage dynamics and marginal costs, and changes in the slope

of the Phillips curve. They conclude that none of these channels can fully account for the changes in the

relationship between ination and unemployment.