Monetary Policy and Labor Market Institutions

In this paper we study how differences in labor market institutions affect the impact of monetary policy on real activity for the U.S. and European countries. We model real shocks as changes in the separation rate of worker-firm matches which can be thought of as a labor demand shock. In expansionary periods (of low separation) output and wages increase which exerts upward pressure on prices. To counteract inflationary tendencies the central bank raises the interest rate which affects the present value of future job-matches and thus reduces posted vacancies, employment and output. Thus we obtain an equilibrium relationship between inflation and unemployment. Institutions interact with shocks which gives rise to substantially different responses for alternative settings of labor market institutions. We calibrate the model to data for the U.S. and several European economies and explicitly consider the role of unemployment benefits as our measure for labor market institutions