Labor market rigidity and the transmission of business cycle shocks

This paper provides a detailed analysis of labor market flows in Germany and compares them to the US. It documents that in Germany average hiring and firing rates are much lower but that the firing rate volatility is 2.5 times larger. This leads to a contribution of 60 − 70% of firings to aggregate unemployment volatility, the opposite of what is found for the US. We document further that wage rigidity is not at the root of the large differences. To explain these cross-country differences we develop a labor market search model with endogenous firings, quits on the job, and skill heterogeneity. We show theoretically that lower average transition rates imply a higher firing rate volatility and amplify the response of the economy to business cycle shocks. We calibrate the model to jointly match stylized labor market facts for the US and Germany. The impulse-response analysis of the model shows that the lower transition rates are also responsible for substantially higher persistence of the unemployment rate in Germany in response to shocks. Thereby, the paper establishes a theoretical link between the effect of labor market institutions and the reaction to business cycle shocks. JEL Classification System: E31, E32, E24, J64