Sectoral shocks, reallocation, and labor market policies

This paper was produced as part of the BIS Consultative Council for the Americas (CCA) research conference on "Structural changes in inflation and output dynamics after Covid and other shocks", held in Mexico City on 17–18 November 2022.

Summary

Focus

Recent recessions, including those of 2007–09 Great Financial Crisis (GFC) and the Covid-19 pandemic, had varying effects across sectors. The policy responses to these recessions too varied across countries. While the United States supported unemployed workers largely by extending unemployment insurance (UI), several European countries expanded short-time work subsidies (WS) to prevent rapid job destruction in affected sectors. These different approaches to fighting recessions raise the questions of which labour market policy, UI or WS, is preferable during recessions, and why did different countries opt for different policies.

Contribution

In this paper, we develop a multi-sector search and matching model to study labour market policy responses to sector-specific shocks. We focus on UI and WS policies, the two labour market policies most used in recent years. The model incorporates key labour market features to address the policy trade-offs commonly discussed: sluggish worker reallocation, inefficient separations and unemployment-induced skill loss. We argue that labour market flexibility, as measured by labour market flows, is crucial in determining which policy is preferred. We use labour market statistics to calibrate two versions of the model: one matched to the US economy (flexible economy) and a second one matched to the euro-area economy (rigid economy). We use the calibrated model to evaluate UI and WS policies in a short-lived recession induced by a sector-specific shock. In our experiment, we recreate the initial shock to the services sector during the first half of 2020, when public health restrictions led to a rapid closure of high-contact services.

Findings

Our main finding is that, in response to a short-lived sectoral shock, the UI policy is preferable in the flexible economy, while the WS policy is preferable in the rigid economy, giving a rationale for the different usage of these policies across countries. In the flexible economy, the UI policy generates a larger initial economic contraction but also a faster recovery. With higher job-finding rates, the UI policy promotes the necessary labour reallocation to unaffected sectors, thus achieving a faster recovery. In contrast, with lower job-finding rates, as in the rigid economy, the UI policy does not generate such a fast recovery, making the WS policy more appealing. The WS policy provides a continuous support for firms' profits, which also proves beneficial for workers.

Abstract

Unemployment insurance and wage subsidies are key tools to support labor markets in recessions. We develop a multi-sector search and matching model with on-the-job human capital accumulation to study labor market policy responses to sector-specific shocks. Our calibration accounts for structural differences in labor markets between the United States and the euro area, including a lower job-finding rate in the latter. We use the model to evaluate unemployment insurance and wage subsidy policies in recessions of different duration. After a temporary sector-specific shock, unemployment insurance improves reallocation toward productive sectors at the cost of initially higher unemployment and, thus, human capital destruction. By contrast, wage subsidies reduce unemployment and preserve human capital at the cost of limiting reallocation. In the United States, unemployment insurance is preferred to wage subsidies when it does not distort job creation for too long. In the euro area, wage subsidies are preferred, given the lower job-finding rate and reallocation.

JEL classification: E24, J64, J68

Keywords: labor market policies, search and matching frictions, reallocation