To investigate the reasons for the persistent rise in European (Euro area) unemployment during the 1990s, especially compared to the USA.
An econometric model of the European labour market is estimated based on the bargaining framework outlined by McDonald and Solow. A data set is constructed by aggregating individual country data. Because of the lack of adequate data, the supply side is treated as an unobserved component and estimated using the Kalman Filter.
The rise in European unemployment is predominately due to the slow and incomplete reaction of the supply side to negative demand shocks in the labour market. The traditional factors which generate low flexibility in the labour market are to blame.
The extent to which the differences in unemployment between the Euro area and the USA can be accounted for by differences in labour productivity is identified as an important issue for future research.
The paper shows how standard bargaining models can be used to explain poor unemployment performance in the Euro area. The approach taken is original in the sense that the European labour market is modelled as a single entity rather than a collection of individual countries, and that unobserved component models are used to overcome the lack of supply side data.
