Labor Market Institutions, Fiscal Multipliers, and Macroeconomic Volatility

Abstract

How do labor market institutions shape the transmission of government spending shocks and macroeconomic volatility? We develop a theoretical model in which labor market institutions affect fiscal transmission through their effect on wage rigidity, job separation, and matching frictions. We estimate an interacted panel vector autoregressive model for 16 OECD economies and study how macroeconomic responses to government spending shocks vary with institutional labor market characteristics. In line with our theoretical predictions, we show that institutions that stabilize employment and wages tend to reduce output volatility and attenuate the response of output and employment to government spending shocks.