Unemployment in an Interdependent World

CESifo Working Paper No. 2788

Unemployment in an Interdependent World

Abstract

We introduce search and matching unemployment into a model of trade with differentiated
goods and heterogeneous firms. Countries may differ with respect to size, geographical
location, and labor market institutions. Contrary to the literature, our single-sector perspective
pays special attention to the role of income effects and shows that bad institutions in one
country worsen labor market outcomes not only in that country but also in its trading partners.
This spill-over effect is conditioned by trade costs and country size: smaller and/or more
centrally located nations suffer less from inefficient policies at home and are more heavily
affected from spill-overs abroad than larger and/or peripheral ones. We offer empirical
evidence for a panel of 20 rich OECD countries. Carefully controlling for institutional
features and for business cycle comovements between countries, we confirm our qualitative
theoretical predictions. However, the magnitude of spill-over effects is larger in the data than
in the theoretical model. We show that introducing real wage rigidity can remedy this
problem.

JEL Code: F11, F12, F16, J64, L11.

Keywords: spill-over effects of labor market institutions, unemployment, international trade,
search frictions, heterogeneous firms.

Mario Larch

Ifo Institute for Economic Research at the
University of Munich
Poschingerstrasse 5

Germany - 81679 Munich
[email protected]

Wolfgang Lechthaler

Kiel Institute for the World Economy

Duesternbrooker Weg 120

Germany - 24105 Kiel

[email protected]

August, 2009

We are grateful to Alan Auerbach, Kerem Cosar, Peter Egger, Christian Haefke, Oleg
Itskhoki, Eckhard Janeba, Philip Jung, Wilhelm Kohler, Peter Neary, Jan van Ours, Julien
Prat, Priay Ranjan, Stephen Redding, Hans-Joerg Schmerer, Hans-Werner Sinn, Cristina
Terra, Lars Vilhuber, and Christoph Weiss as well as to seminar participants at the GEP-IFN
Workshop in Stockholm 2008, the SED Annual Meeting in Istanbul 2009, the NOeG
conference 2009 in Linz, the CEA Meetings 2009 in Toronto, the CESifo Institute Munich,
the Kiel Institute for the World Economy, the University of Cergy-Pontoise, the University of
Erfurt, the University of Innsbruck, the University of Mannheim, and the University of
Tuebingen for comments and remarks. All remaining errors are ours.

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