Labour-Market Institutions and Macroeconomic Shocks

Abstract

Macroeconomic shocks and labour-market institutions jointly determine employment growthand economic performance. The effect of shocks depends on the nature of these institutionsand the effect of institutional change depends on the macroeconomic environment. It followsthat a given set of institutions may be appropriate at certain times in some countries while notappropriate elsewhere. We derive a dynamic model of labour demand in which the effect offiring costs on labour demand depends on the macroeconomic environment: When the levelof macroeconomic activity is expected to drop and/or the trend rate of productivity growth issmall, a rise in firing costs affects mainly (and adversely) the hiring decision and not the firingdecision. This makes firing costs harmful when they may appear to be most appropriate. Theintuition behind these results is quite straightforward: When managers fear that demand mayfall in the future they value the right to fire workers. It follows that by making this option morecostly, firing costs reduce the value of workers with adverse consequences for hiring andfiring.

Keywords: firing costs, stochastic demand, hiring and firing, real options

JEL Classification: E32, J23, J24, J54