Empirical Evidence on the Cost of Adjustment and Dynamic Labour Demand

In this paper the author examines whether there is significant evidence of the effect of adjustment costs on Canadian labour demand. This is an important question, as sluggish adjustment of labour demand resulting from significant adjustment costs may be one factor that could help explain some of the unemployment persistence found in Canadian data. The author uses a linear-quadratic model and attempts to estimate the relative adjustment costs of labour demand as well as its rate of adjustment towards long-run equilibrium. In contrast to others who have examined the dynamic behaviour of labour demand, the author estimates the structural parameters using the Euler equation and employs a limited-information approach that does not require an explicit solution for the model's control variables in terms of the forcing processes. The empirical estimates imply that adjustment costs are about four times more important than disequilibrium costs and that it takes over three and a half years for 90 per cent of labour demand adjustment to be completed. Therefore the author concludes that significant adjustment costs are an important feature of Canadian labour demand and that sluggishness due to these costs may be one explanatory factor in unemployment persistence.