Labor market institutions and the business cycle: The role of unemployment fears

Abstract

We study the effects of labor market institutions (LMIs) in a general equilibrium model with search and matching frictions, endogenous separations, nominal rigidities, and uninsurable unemployment risk. By contrasting the US and EA, which are characterized by different degrees of employment protection and unemployment insurance schemes, we show that these LMIs have important implications for the transmission of standard aggregate demand and (even more so) supply shocks. In particular, if US unemployment benefits were increased during recessions to the levels typically observed in the EA, fluctuations in employment could be significantly reduced, bringing the outcomes close to the case of full unemployment insurance assumed by representative agent models. Similar effects can be obtained by subsidizing wages or introducing partial employment protection during recessions, especially if these are driven by changes in aggregate productivity.