Unemployment in an Interdependent World

the home country’s labor market frictions raises unemployment in the foreign country ”.⁶
Since, the effect of institutions on home unemployment is ambiguous, a negative correla-
tion between the home and the foreign unemployment rate is possible (and likely). The
key to understand this result is to recognize that foreign labor market institutions affect
unemployment in the domestic market only through trade openness and the fraction of
firms that export. Lower variable trade costs and higher foreign labor market frictions
increase unemployment in the domestic country by raising the fraction of home firms that
export. The increase of firms that export in the domestic market leads to a shift of the
industry composition of low- to high-productivity firms. As more productive firms are
more selective, unemployment goes up.

Egger, Greenaway, and Seidel (2008) obtain a similar relationship between labor mar-
ket institutions and unemployment at home and abroad. They use a multi-country, new
economic geography model of trade with mobile capital, where unemployment exists due
to fair wage preferences of workers. They find that: “A marginal increase in the fair wage
parameter” increases “the unemployment rate of [the home] country while more employ-
ment is generated in all other countries. A marginal variation in the replacement rate has
similar effects.” (Proposition 1)

Hence, recent theoretical papers mostly suggest a negative relationship between the
effects of labor market institutions at home and abroad.⁷ In contrast, our theoretical
model predicts a positive correlation between bad labor market institutions at home and
unemployment abroad, which is strongly supported by our empirical analysis. Also in line
with our theoretical predictions, the data suggests an important role for country size and
geography to condition institutional spill-overs.

The remainder of the paper is structured as follows. Section 2 outlines the theoretical
model. Section 3 explores the interdependence of labor market outcomes and unemploy-
ment of our theoretical model. In section 4 we provide empirical evidence for the key
predictions of our model. The last section concludes. The paper focuses on unemploy-
ment. Results pertaining to wage effects are relegated to the appendix.

⁶Proposition 6, part (iii) in Helpman, Itskhoki, and Redding (2008b).

⁷Note that the model from Helpman, Itskhoki, and Redding (2008) would suggest that the correlation
between bad labor market institutions at home and home unemployment would be negative, whereas
the correlation with foreign unemployment would be positive. The predictions form the model of Eg-
ger, Greenaway, and Seidel (2008) would exactly be the opposite: The correlation of bad labor market
institutions with home unemployment would be positive, whereas it would be negative with foreign un-
employment. The papers by Beissinger and Büsse (2001, 2002) are the only contributions where the
correlation between domestic and foreign unemployment is unambiguously positive and driven by a gen-
eral equilibrium income effect. In contrast to these papers, we allow for entry and exit of heterogeneous
firms, do not assume a frictionless economy, and focus on the dependence between trade costs and labor
market spill-overs.

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