Can Active Labour Market Policy Work? Some Theoretical Considerations

Persistent high unemployment in Europe has led to renewed interest in Active Labour Market Policy. However, most existing theory suggests that its effects are ambiguous at best. We argue that job search assistance and wage subsidies are more appropriately modelled as a transition rather than the state-based approach of existing theory. This eliminates the ambiguity. We present two main models, one in which negative duration dependence in unemployment arises from state dependence, the other where it is due to heterogeneity. In both cases policy is unambiguously effective provided it is targeted on those who are, or are most likely to become, long-term unemployed. Some crude estimates suggest that Active Labour Market Policies could have a significant, though not spectacular, effect in reducing unemployment.