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Reconciling the Relevance of Labor Market Institutions in Search and Matching Models with International Evidence

February 20, 2012
Wataru Hirata*1

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Abstract

This paper examines whether search and matching frictions in labor markets can account for cross-country differences in business cycle properties. The particular interest is the joint effect of two institutional variables, employment protection and the replacement income of unemployed workers. I first document an empirical regularity that higher degrees of employment protection and/or lower replacement rates are associated with larger standard deviations of real wages relative to those of unemployment in OECD members. However, there is a positive correlation between employment protection and replacement rates implying that the net effect of the systematic difference in these institutional variables could be ambiguous. I then show that modern macroeconomic models with search and matching frictions are broadly consistent with the stylized fact: the models predict that higher firing costs and/or lower replacement rates raise the wage volatility relative to that of unemployment. I find that this result is robust to alternative setups of non-labor markets. Finally, I find that the effect of the above institutions on inflation is minor.

JEL classification
E24; E31; E32; J63; J64; J88

Keywords
search and matching frictions, labor market institutions, cyclicalities, real wage, unemployment

I would like to thank Kosuke Aoki, Toshitaka Sekine and participants in a University of Tokyo seminar as well as a lunch time workshop held at the Institute for Monetary and Economic Studies. Any remaining errors are my own. The views expressed in this paper are not necessarily those of the Bank of Japan.

  •   *1 Research and Statistics Department
    E-mail : wataru.hirata@boj.or.jp

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