Unemployment and Aggregate Demand in Spain

The paper contributes to the existing literature by incorporating the Keynesian principle of weak aggregate demand into the basic search-matching model of unemployment in a simple and novel way. Multiple equilibrium unemployment rates emerge as a result of this modification. It is shown that output demand not only plays short-term role but might be essential in the long-run as well. This is because the initial fall in aggregate demand may cause unemployment rate to converge to a higher (long-run) equilibrium. All these aspects are illustrated for the Spanish labour market and it is shown that the model with multiple equilibrium unemployment rates outperforms the baseline standard search and matching model in its forecasting performance as well as in its ability to describe huge persistent swings in unemployment.