The employment and output of Nations: Theory and policy implications

Abstract

I build a dynamic general equilibrium model that is consistent with the trends in the participation, unemployment and employment rates for the US and major European economies over the last 50 years. I then use the model to study the interdependence of non-competitive labor and product markets in order to shed light on the effects of institutions and policies on employment and output. Unemployment harms output because it inserts a wedge between labor supply (participation) and employment. The distribution of income across wages and profits plays a central role in the economy's dynamics. The reason is that the wage share drives the labor market participation decisions of households, while the profit share drives the entry decisions of firms. Intuitively, one can think of entry decisions as another participation margin. I uncover feedback mechanisms linking the two markets that amplify the adverse effects on output of labor and product market frictions. These mechanisms have interesting policy implications.