Presentation given during the Project LINK meeting, New York, October 2010

1. Macroeconomic policy and employment flows
Labour market adjustment mechanisms in macroeconomic models
Uma Amara Rani Matthieu Charpe Ekkehard Ernst
International Institute for Labour Studies, ILO
Project LINK meeting, New York
Oct 22nd, 2010

2. Outline
1 Objectives and main message
2 Background considerations
3 A labour market flows macro model
4 Model estimation
5 Conclusion
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 2 / 22

3. Objectives and main message Objectives
Objectives
Get a micro picture of labour dynamics
Look at different margins of labour market flows
Job creation vs. job destruction
Assess their dynamics over the cycle
Overcoming Okun’s fatality
Okun’s law is time-varying and asymetric
How to promote job-rich growth?
How does weak employment growth affect the
recovery?
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 3 / 22

4. Objectives and main message Bottom line
Main message
Important insights from analysing labour flow dynamics
Stark differences in labour flow dynamics over the
business cycle
Labour flow dynamics adds to the macro-economic
feedback loops
Large (short-run) employment multipliers (> 1), lower
in the long-run (due to automatic stabilization)
Scenario analysis suggests huge fiscal benefits to be
had from additional stimulus
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 4 / 22

5. Background considerations Traditional macro models
Traditional macro models
Okun’s law as a corner stone
Pre-determined employment elasticities of growth:
Symmetric relation between output and employment growth
Trickle-down effects of stimulus
Trickle down effects of stimulus:
First investment, than jobs (IMF: resilient recovery)
Improved demand side will eventually lead to more (and
better?) jobs
But:
Strong evidence for time-varying Okun’s law before the crisis
Crisis makes elasticity approach obselete
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 5 / 22

6. Background considerations Labour flow macro models
Building labour flows into macro models
Labour flow macro models
Since the mid-1990s, labour flows introduced in DSGE models
Merz, 1995; Andolfatto, 1996; Trigari, 2003; Walsh, 2005
Increasingly becoming the industry standard
Most New Keynesian models now contain labour flows
Recent fiscal policy models exclusively rely on them
But:
Problems with the business cycle behaviour of flows
Volatility not high enough to match data (Shimer, 2005)
Unrealistic wage behaviour
Estimation of the model difficult
Internationally comparable data on labour flows hardly available
Strong assumptions wrt functional form and parameter distribution
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 6 / 22

7. A labour market flows macro model Labour market flows and matching
Stylised facts on labour flows
Labour market flows present stark differences across
countries over the business cycle
Canada Germany
−3
2
−4
0
−2
−5
Outflow probability
Inflow probability
−4
−6
Japan USA
−3
2
−4
0
−2
−5
−4
−6
1970 1980 1990 2000 2010 1970 1980 1990 2000 2010
Unemployment outflows Unemployment inflows
Note: Flow probabilities have been logit−transformed
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 7 / 22

8. A labour market flows macro model Determinants of labour flows
Labour flow accounting
Decomposing unemployment dynamics
Ut = Lt − ETt = INt − OUTt
Decomposing employment creation
ETt = JobCreationt − JobDestructiont
⇓
Link unemployment in- and outflows to its determinants
Job creation
Job destruction
Labour force growth
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 8 / 22

9. A labour market flows macro model Determinants of labour flows
What drives labour market flows?
Job creation
Investment growth, private consumption, external demand
Past employment rate, wages
User cost of capital, Real share prices
Job destruction
Wages, real interest rates, tax wedge, external demand
Schumpeter effect: TFP, Import growth
Labour force dynamics
Mainly driven by its own history plus
Tax incentives
Discouraged worker effects
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 9 / 22

10. A labour market flows macro model A macro framework
A macro framework I
Financial accelerator
Interest rates affect net present value of
vacancies
Real share prices improve investment dynamics
Feedback loops
In- and outflows feed into AD through
Government spending
Disposable income
Wages
Government spending feeds into
disposable income
private investment
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 10 / 22

11. A labour market flows macro model A macro framework
A macro framework II
Double Phillips curve
Hybrid Phillips curve for price dynamics
Wage dynamics dependent on
unemployment flows
Taylor rule, depending on
Expected inflation and output gap
Government balances
Automatic stabilisers, related to
Unemployment in- and outflows
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 11 / 22

12. Model estimation Data and methodology
Data and methodology
Data
Macro data from OECD Economic Outlook 87
Unemployment flow data from Elsby et al. (2008)
Estimated flows based on LFS information on
unemployment duration
Match job creation/destruction rates under certain
assumptions
Methodology
Start with single-equation identification
Then estimate system of equations
Full macro-model on the basis of GMM
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 12 / 22

13. Model estimation Single equation identification
Determinants of job creation
Decomposition of unemployment outflows shows that:
Demand components play an important role (>40%)
Indication for some financial accelerator effect (>30%)
Relative prices (wages) more moderate role (<20%)
60
17.4
Contributions to unemployment outflows (in %)
40
14.1
11.8
20
10.9
0
−3.6
−20
−19.0
−40
−23.1
User cost
of capital
Real wage
growth
Employment rate
(lagged)
Capital stock
growth
Growth of real
share prices
External demand
Real disposable
income growth
Total
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 13 / 22

14. Model estimation Single equation identification
Determinants of job destruction
Decomposition of unemployment inflows
No Schumpeterian effect from import penetration (strong demand effect)
Job churning due to changes in interest rates and TFP growth
23.0
50
Contributions to unemployment inflows (in %)
14.0
25
10.9
0
−9.0
−25
−20.1
−50
−22.9
Growth of
real imports
External demand
Changes in
Terms of Trade
Labour force
growth
Growth of Total
Factor Productivity
Real short−term
interest rate
Total
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 14 / 22

15. Model estimation System-equation approach
Estimation
Two-step procedure
System-equations approach to understand the
impact of different policies
Use GMM to estimate the full macro model
Steady-state analysis
Dynamic system allows for unique steady state
(details in the paper)
Allows to differentiate between short- and
long-run effects of policies
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 15 / 22

16. Model estimation System-equation approach
Short- and long-run employment multipliers
Policy contributions to outflows (short− vs. long−term) Policy contributions to inflows (short− vs. long−term)
Government Government non− Government wage Government Government wage Government non−
spending wage spending spending spending spending wage spending
40
40
20
20
Contributions (in %)
Contributions (in %)
0
0
40 −20
40 −20
Contributions (in %)
Contributions (in %)
20
20
0
0
−20
−20
Unemployment Hiring Training Public employment Direct job Training Public employment Hiring Unemployment Direct job
benefits incentives expenditures services creation expenditures services incentives benefits creation
Short−term effect Long−term effect Short−term effect Long−term effect
on outflows on outflows on inflows on inflows
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 16 / 22

17. Model estimation Dynamic model simulation
Business cycle
Constant INt−1 LFPRt−1 ∆TFPt−1 RIRSt−1 TaxIndt−1 Gapt OUTt
(1) INt -3.503*** 0.593*** 1.141*** 0.465*** 0.009*** 2.032*** -0.021*** -0.032***
(0.139) (0.019) (0.095) (0.028) (0.001) (0.237) (0.001) (0.009)
Constant OUTt−1 ETRt UCCt ∆WRt ∆INVt Gapt INt
(2) OUTt -1.311*** 0.606*** 1.790*** -0.008*** -0.868*** 3.517*** 0.031*** 0.145***
(0.145) (0.014) (0.135) (0.002) (0.108) (0.205) (0.002) (0.018)
Constant RIRSt−1 E {GAPt+1 } GovConst−1 TAXt−1 E {πt+1 }
(3) RIRSt 1.201** 0.791*** 0.076*** 4.756** -6.247*** 5.168***
(0.539) (0.012) (0.016) (1.971) (1.322) (1.138)
Constant E {RSharet+1 } GovInvt−1 ∆Prodt−1 RIRLt−1 ∆ETt−1 GAPt−1
(4) INVt 0.007 0.011*** 0.350** 0.831*** -0.001*** 0.473*** 0.001***
(0.006) (0.002) (0.154) (0.051) (0.000) (0.023) (0.000)
Constant OUTt INt−1 ∆INVt−1 GovConst−1 TAXt−1 ∆NetExportst−1
(8) GAPt -12.931*** 1.620*** -1.940*** 56.495*** 22.651*** -30.290* 0.001***
(1.918) (0.136) (0.388) (4.624) (2.083) (18.368) (0.000)
Constant πt−1 E {πt+1 } ∆ToTt−1 GAPt−1
(9) πt 0.001*** 0.500*** 0.489*** -0.044*** 0.001***
(0.000) (0.012) (0.013) (0.008) (0.000)
Constant ∆WSSEt−1 ∆ETt−1
(10) ∆WSSEt 0.006*** 0.792*** 0.146***
(0.001) (0.011) (0.039)
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 17 / 22

18. Model estimation Application: Understanding recovery options
Alternatives to austerity I
Analysing crisis exit scenarios
Early consolidation (individually or globally)
Additional spending
Government deficit
0.0
Government net lending
−0.5
(in % of GDP)
−1.0 −1.5
2005 2010 2015 2020
Baseline scenario Early withdrawal
Global fiscal Additional spending for
consolidation 3 years (3% of GDP)
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 18 / 22

19. Model estimation Application: Understanding recovery options
Alternatives to austerity II
Substantially different employment patterns
Additional stimulus pushes up employment growth beyond trend
within 2 years
With consolidation the gap will not be closed at the end of the
forecast period
Employment growth
0.2
Annual rate of employment growth
−0.6 −0.4 −0.2 0.0
(in %)
−0.8
2005 2010 2015 2020
Baseline scenario Early withdrawal
Global fiscal Additional spending for
consolidation 3 years (3% of GDP)
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 19 / 22

20. Model estimation Application: Understanding recovery options
Alternatives to austerity III
Distinct transmission mechanisms of policies
Additional spending works mainly through higher outflows
Fiscal consolidation depresses outflows AND increases inflows
Unemployment outflows Unemployment inflows
0.3
2.0
Rate of unemployment outflows
Rate of unemployment inflows
0.2
1.5
0.1
1.0
0.1
0.5
0.1
0.0
2005 2010 2015 2020 2005 2010 2015 2020
Baseline scenario Early withdrawal Baseline scenario Early withdrawal
Additional spending for 3 years (3% of GDP) Global fiscal consolidation Additional spending for 3 years (3% of GDP) Global fiscal consolidation
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 20 / 22

21. Conclusion Summary
Summary
How should countries adjust their exit strategies?
1 Labour market policies more effective than generic
government spending
2 Focus on measures that contribute to automatic
stabilization
3 Additional stimulus might have positive fiscal implications
4 Premature consolidation packages will be damaging on both
flow margins
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 21 / 22

22. Conclusion Future extensions
Way forward
Coverage of country specificities
1 Increase country coverage (developing economies)
2 Consider more complex labour market flows
3 Estimate country-specific models
Extend the macro framework
1 Financial market interactions à la Wasmer and Weil (2004)
2 Enrich policy framework to cover different policy instruments
3 This includes proper treatment of monetary policy
4 Calibrate the model to make it fit for forecasting
Amara, Charpe, Ernst (ILO) Macro policy and employment flows Oct 2010 22 / 22