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

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.