Labor Market Institutions and Wage and Inflation Dynamics

Abstract

This paper developes a New Keynesian (NK) model that incorporates standard search and matching structure with firing costs. I analyze how labor market institutions affect the macroeconomic dynamics, in particular, wage and inflation dynamics. I particularly look at two important labor market institutions namely unemployment benefits and firing costs. I find that in countries where unemployment benefits are higher and there are more strict employment protection legislations, inflation and wages become less volatile and more persistent. I also find that the level of these labor market institutions affect how wages and inflation respond to exogenous shocks, in particular, to productivity and monetary policy shocks. I first present some empirical evidence that shows a cross-country link between labor market institutions and wages and inflation. Then I build a dynamic stochastic general equilibrium model which provides theoretical support for this empirical evidence.