The equilibrium rate of unemployment and policies to lower it: The case of Finland

The paper combines the short-run link between increases in aggregate demand and growth of GDP, which leads to a reduction in unemployment, with a definition of the equilibrium rate of unemployment that is independent of the growth rate. We first present evidence from the EU and the US that expected changes in the growth rate of GDP do not have, while unexpected shocks do have, an effect on the change in unemployment, in line with the equilibrium rate model. A novel structural model, allowing for this distinction, is then constructed and estimated for the Finnish labour market. We solve for the equilibrium rate of unemployment and the standard error of this estimate, and evaluate policies to lower the still quite high equilibrium rate or to accelerate adjustment towards it. Reducing the replacement rate is a feasible policy option to lower unemployment permanently, although its effects will be felt only slowly. A more competitive product market and a permanent moderation in wage claims also lead to a lower equilibrium level of unemployment. Expansionary demand management policies, even though their effect is neutralised in the medium run, can, if properly designed, accelerate adjustment towards the equilibrium rate. Due to slow adjustment in the labour market, temporary wage restraint and a reduction in payroll taxes are also effective tools over the medium run, although they do not have an effect on the long-run steady state.