Unemployment, Growth and Fiscal Policy: New Insights on the Hysteresis Hypothesis

We develop a growth model with unemployment due to imperfections in the labor market. In this model, wage inertia and balanced budget rules cause a complementarity between capital and employment capable of explaining the existence of multiple equilibrium paths. Hysteresis is viewed as the result of a selection between these different paths. We use this model to argue that, in contrast to the United States, those fiscal policies followed by most of the European countries after the shocks of the 1970s may have played a central role in generating hysteresis. © 2006 Cambridge Univereity Press.