4 costs of inputs, loss of competitiveness and, for the first time, hard budget constraints .] After some adjustment in production levels and reallocation of resources, various relative shocks ensued. Changes in relative costs and the collapse of domestic demand led to additional compression in productive activity, thus creating fiscal pressure. The ensuing high inflation proved destabilizing to the macroeconomic situation (see Table 2). The degree of labor shedding over this tumultuous period, however, was more moderate. The decline in output considerably exceeded the decline in employment, signifying continued labor hoarding and soft budget constraints initially, with reliance on attrition, extended unpaid vacation, early retirement, and exit from the labor force. The relatively moderate rates of unemployment can be explained by: (i) the discrepancy between the level of official, registered unemployed, and the level of _de facto_ unemployed; (ii) exit from the labor force; and (iii) measurement problems associated with informal sector activity. Labor market surveys in Russia, for example, yield significant discrepancies in the magnitude of unemployment relative to the official numbers (Commander and Yemtsov, 1995).

7. The success of the new UI programs has not been uniform across the CEE countries. Since initially implemented, several countries have adjusted the benefit parameters in the direction of tighter eligibility requirements, shorter durations or lower replacement rates, because of spiraling costs, which led to a squeeze on financing for active labor market policies. Counterexamples are provided by Poland and Romania, which experienced particularly high rates of unemployment and declines in living standards early in the transition period. Poland extended its duration maximum to 18 months in regions deemed to be in particular crisis, and Romania added a "social benefit" provision at a very low level of support (40 percent of the minimum wage, means-tested only), to last 18 months in addition to the regular benefit duration of up to 9 months, bringing the total duration to greater than two years. Despite the intention to increase protection of vulnerable populations, introducing more generous benefits at critical stages of adjustment is equivalent to backtracking on reforms, and can have serious and persistent negative consequences for the labor market. The model discussed in the next section illustrates the potentially damaging result of hysteresis in terms of entrenched long-term unemployment and the associated risk of marginalizing an important segment of the labor market.

# **Section II:** A **Dynamic Model of the Labor Market**

8. In his recent labor market analyses (Burda, 1988, 1992, 1993; Commander and Coricelli, 1995) Michael Burda develops a model to describe the effects of various labor market institutions in a unified framework, with the goal of analyzing the evolution of unemployment over the medium and long terms. Although short-run price and demand shocks are not unimportant, the model addresses the long-run dynamics of the labor market. The model is therefore useful in describing economies in transition whose labor markets are undergoing drastic change.

_1/_ Commander and Coricelli (1993) find that negative growth in output is fairly uniform across sectors, suggesting that aggregate shocks play a significant role.