The purpose of this paper is twofold. First, it reviews the model of search and matching equilibrium and derives the properties of employment and unemployment equilibrium. Second, it applies the model to the study of employment fluctuations and to the explanation of differences in unemployment rates in industrialized countries. The search and matching model is built on the assumptions of a time-consuming matching technology that determines the rate of job creation given the unmatched number of workers and jobs; and on a stochastic arrival of idiosyncratic shocks that determines the rate of job destruction given the wage contract between matched firms and workers. The outcome is a model for the flow of new jobs and unemployed workers from inactivity to production (the ‘job creation' flow) and one for the flow of workers from employment to unemployment and of jobs out of the market (the ‘job destruction' flow). Steady-state equilibrium is at the point where the two flows are equal. The model is shown to explain well the employment fluctuations observed in the United States economy, within the context of a real business cycle model. It is also shown that the large differences in unemployment rates observed in industrialized countries can be attributed to a large extent to differences in policy towards employment protection legislation (which increases the duration of unemployment and reduces the flow into unemployment) and the generosity of the welfare state (which reduces job creation). It is argued that on the whole European countries have been more generous in their unemployment support policies and in their employment protection legislation than the United States. The paper also surveys other reasons given in the literature for the observed levels in unemployment, including mismatch and real interest rates.
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Paper provided by Centre for Economic Performance, LSE in its series CEP Discussion Papers with number
0421.
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