Reassessing the Role of Labor Market Institutions for the Business Cycle

Abstract

This paper investigates empirically the effect of labor market institutions (LMIs) on business cycle fluctuations. Most studies, using a cross-country panel approach, have found a weak effect of LMIs on unemployment and, especially, inflation dynamics. In this paper, we estimate an interacted panel VAR for OECD countries, where we allow the dynamics of inflation, unemployment, and the interest rate to vary with the characteristics of the labor market. We find that LMIs have a large and significant effect on both unemployment and inflation dynamics. Stricter employment protection legislation and higher union density mute the reaction of unemployment but increase the response of inflation to external shocks. The opposite effects are found for the generosity of the unemployment benefit system and the extent of the tax wedge. Countries with decentralized wage bargaining manage to absorb shocks through lower variations in unemployment. Our results imply that countries with very rigid or very flexible labor markets can have similar inflation and unemployment dynamics.

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