An advantage of a multi-equation labour market model over a single unemployment
rate equation, is that growing nonstationary variables (e.g. capital stock) can be included
alongside the usual stationary ones (e.g. tax rates) to determine the unemployment rate.
In addition, our model includes nationwide as well as region-specific variables. This will
allow us to distinguish between idiosyncratic and nationwide labour market shocks.
The CRT postulates that the evolution of unemployment is driven by the interplay
of lagged adjustment processes and the spillover effects of the shocks within the labour
market system.5 The implication is that unemployment can be viewed as the outcome
of prolonged adjustments to changes in both stationary and growing variables. Since
different regions may be exposed to different types of shocks and experience different
adjustment processes, our approach incorporates elements of both the equilibrium and
disequilibrium interpretations of regional disparities given above.
Our labour market model also takes into account the limited labour and firm mobility
in Spain, and generally in Europe.6 Workers do not move as a result of scant wage
differentials (due, for example, to centralised wage bargaining), substantial housing price
differentials, and family ties. Firms do not move as they tend to agglomerate in certain
regions in order to enjoy the agglomeration externalities (see Puga, 1999).
Specifically, we show that disparities in regional unemployment rates depend on
• The regional spillover effects, i.e. on how shocks feed through the labour market
system. Different feedback mechanisms generate different unemployment responses
even when regions face shocks of the same type and size (e.g. an oil price increase).
• The degree of regional labour market flexibility. Labour market flexibility is a func-
tion of the interplay of lagged adjustment processes and spillover effects. Unem-
ployment trajectories diverge because some regions adjust faster than others.7
Our analysis seeks to answer the following questions. How does the degree of labour
market flexibility differ between regions that face the same type and size of shocks?
How have the various region-specific and nationwide explanatory variables contributed
to regional unemployment? How has unemployment responded to actual shocks, i.e. the
changes in the explanatory variables?
The rest of the paper is organised as follows. Section 2 presents an analytic model
that illustrates the interactive dynamics approach of the Chain Reaction Theory of un-
employment. Section 3 outlines the structure of the labour market model for the Spanish
regional unemployment rates. Section 4 discusses data and estimation results. Section
5 evaluates the persistence of unemployment to wage-setting, labour demand and supply
shocks. Section 6 measures the contributions of the exogenous variables to the evolution
5 Spillover effects arise when shocks to a specific equation feed through the labour market system.
6 This reinforces the equilibrium interpretation of regional disparities.
7 The fact that all regions within a country are subject to the same labour market institutions does
not imply that all regions will have identical lagged adjustment processes. For example, employment
adjustment is not only related to firing costs - these are common to all regions as they are determined
by the legal system - but also to hiring and training costs, which may be region-specific.