The natural rate of unemployment and its institutional determinants

This chapter explains movements in the natural rate of unemployment by considering both institutional labour market measures and persistent demand shocks. The study uses a panel data set for 28 EU countries covering 1985-2018. The following institutional variables are found to be key drivers of the natural rate: (i) a measure of the unemployment benefit replacement rate; (ii) a labour tax wedge indicator; and (iii) spending on active labour market policies. Additional elements that have a bearing on the natural rate include demographic factors associated with population ageing - have played a historical role, and persistent demand shocks. The latter developments are related to crisis episodes, such as the unwinding of unsustainable expansions in the housing market. The results suggest that, for a number of countries, the natural rates in 2018 were lower than during the previous business cycle peaks - for example, in 2000 or in 2007 - mainly because of changing demographics, rather than positive cyclical developments (the demand shocks).