Natural Unemployment and Activity Rates in Italy: Flow-based Determinants and Implications for Price Dynamics

Abstract

Abstract Despite the magnitude and cyclicality of transitions into and out of the labor force, the literature generally considers unemployment as a sufficient statistic of labor market slack. We question this view by jointly estimating natural unemployment and participation rates through a Phillips curve informed by structural labor market flows. Focusing on Italy, a country where flows into and out of the labor force are particularly large, we find that the participation margin accounts for a significant share of total slack and explains one third of the missing inflation that followed the 2011 Sovereign Debt Crisis. Exploiting a reform that sharply and unexpectedly increased the statutory retirement age and expanded labor supply without directly affecting unemployment, we confirm that neglecting the participation gap biases inflation forecasts.