Reconciling the Relevance of Labor Market Institutions in Search and Matching Models with International Evidence

This paper examines whether search and matching frictions in labor markets can account for cross-country differences in business cycle properties. The particular interest is the joint effect of two institutional variables, employment protection and the replacement income of unemployed workers. I first document an empirical regularity that higher degrees of employment protection and/or lower replacement rates are associated with larger standard deviations of real wages relative to those of unemployment in OECD members. However, there is a positive correlation between employment protection and replacement rates implying that the net effect of the systematic difference in these institutional variables could be ambiguous. I then show that modern macroeconomic models with search and matching frictions are broadly consistent with the stylized fact: the models predict that higher firing costs and/or lower replacement rates raise the wage volatility relative to that of unemployment. I find that this result is robust to alternative setups of non-labor markets. Finally, I find that the effect of the above institutions on inflation is minor.