The Employment (and Output) of Nations: Theory and Policy Implications

Abstract

I study the effects of product and labor market frictions in a dynamic general equilibrium model with a three-states representation of the labor market. Firms bargain with unions over wages and employment levels. This generates unemployment. Households take the associated unemployment risk as given in making participation and consumption-saving decisions. Unemployment harms output because it inserts a wedge between labor supply (participation) and employment. New firms make entry decisions based on expected future profitability as determined by macroeconomic conditions. The model produces dynamics consistent with the long-run trends exhibited by the US and EU15 economies over the last 40-50 years. It also features feedback mechanisms linking the two markets that amplify the adverse effects on output of labor and product market frictions. These multiplier effects have interesting policy implications.