Employment Protection and Business Cycles in Emerging Economies
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1 Employment Protection and Business Cycles in Emerging Economies Ruy Lama IMF Carlos Urrutia ITAM August, 2011 Lama and Urrutia () Employment Protection August, / 38
2 Motivation Business cycles in emerging economies display substantial di erences with the pattern observed in developed economies. Higher GDP volatility. Lama and Urrutia () Employment Protection August, / 38
3 Motivation Business cycles in emerging economies display substantial di erences with the pattern observed in developed economies. Higher GDP volatility. Higher consumption volatility. Lama and Urrutia () Employment Protection August, / 38
4 Motivation Business cycles in emerging economies display substantial di erences with the pattern observed in developed economies. Higher GDP volatility. Higher consumption volatility. Higher countercyclicality of trade balance. Lama and Urrutia () Employment Protection August, / 38
5 Motivation Lama and Urrutia () Employment Protection August, / 38
6 Motivation Lama and Urrutia () Employment Protection August, / 38
7 Motivation Lama and Urrutia () Employment Protection August, / 38
8 Motivation Lama and Urrutia () Employment Protection August, / 38
9 Possible Explanations 1 Di erent stochastic processes of TFP for emerging economies. Aguiar and Gopinath (2007). Lama and Urrutia () Employment Protection August, / 38
10 Possible Explanations 1 Di erent stochastic processes of TFP for emerging economies. Aguiar and Gopinath (2007). 2 Di erent shocks to external nancing conditions. Neumeyer and Perri (2005). Lama and Urrutia () Employment Protection August, / 38
11 This Paper We evaluate the role of employment protection in shaping business cycles in emerging economies. Lama and Urrutia () Employment Protection August, / 38
12 This Paper Table 1: Business cycles Properties and Employment Protection Across Countries s.d.(y) s.d.(l) /s.d.(y) Employment Protection (weeks) (percent) DBI H&P Argentina Brazil Chile Colombia Mexico Average Emerging Australia Canada Norway New Zealand United Kingdom Average Developed Lama and Urrutia () Employment Protection August, / 38
13 This Paper A canonical small open economy model calibrated to Mexico. Lama and Urrutia () Employment Protection August, / 38
14 This Paper A canonical small open economy model calibrated to Mexico. Search frictions and endogenous separation. Lama and Urrutia () Employment Protection August, / 38
15 This Paper A canonical small open economy model calibrated to Mexico. Search frictions and endogenous separation. Key Mechanism: Selection E ect. Lama and Urrutia () Employment Protection August, / 38
16 This Paper A canonical small open economy model calibrated to Mexico. Search frictions and endogenous separation. Key Mechanism: Selection E ect. Over the cycle least productive workers are dismissed rst, raising average productivity of rms. Lama and Urrutia () Employment Protection August, / 38
17 This Paper A canonical small open economy model calibrated to Mexico. Search frictions and endogenous separation. Key Mechanism: Selection E ect. Over the cycle least productive workers are dismissed rst, raising average productivity of rms. Employment protection limits the selection e ect, resulting in lower productivity during recessions. Lama and Urrutia () Employment Protection August, / 38
18 This Paper A canonical small open economy model calibrated to Mexico. Search frictions and endogenous separation. Key Mechanism: Selection E ect. Over the cycle least productive workers are dismissed rst, raising average productivity of rms. Employment protection limits the selection e ect, resulting in lower productivity during recessions. We evaluate the role of employment protection in exacerbating business cycles in emerging economies. Lama and Urrutia () Employment Protection August, / 38
19 This Paper A canonical small open economy model calibrated to Mexico. Search frictions and endogenous separation. Key Mechanism: Selection E ect. Over the cycle least productive workers are dismissed rst, raising average productivity of rms. Employment protection limits the selection e ect, resulting in lower productivity during recessions. We evaluate the role of employment protection in exacerbating business cycles in emerging economies. What would happen if ring costs in Mexico are reduced to level observed in Canada? Lama and Urrutia () Employment Protection August, / 38
20 Results 1 Lower ring costs reduces output volatility by 15 percent. Lama and Urrutia () Employment Protection August, / 38
21 Results 1 Lower ring costs reduces output volatility by 15 percent. Explains 1/3 of the discrepancy between volatility in emerging and developed economies (2.17 in Mexico vs in Canada). Lama and Urrutia () Employment Protection August, / 38
22 Results 1 Lower ring costs reduces output volatility by 15 percent. Explains 1/3 of the discrepancy between volatility in emerging and developed economies (2.17 in Mexico vs in Canada). 2 Lower output decline of 1.3 percentage points during the Great Recession. Lama and Urrutia () Employment Protection August, / 38
23 Results 1 Lower ring costs reduces output volatility by 15 percent. Explains 1/3 of the discrepancy between volatility in emerging and developed economies (2.17 in Mexico vs in Canada). 2 Lower output decline of 1.3 percentage points during the Great Recession. Decline of 7.6 percent instead of the actual 8.9 percent. Lama and Urrutia () Employment Protection August, / 38
24 Results 1 Lower ring costs reduces output volatility by 15 percent. Explains 1/3 of the discrepancy between volatility in emerging and developed economies (2.17 in Mexico vs in Canada). 2 Lower output decline of 1.3 percentage points during the Great Recession. Decline of 7.6 percent instead of the actual 8.9 percent. 3 Search and endogenous separation explains 30 percent of total labor frictions (Labor Wedge). Lama and Urrutia () Employment Protection August, / 38
25 Outline 1 Related Literature Lama and Urrutia () Employment Protection August, / 38
26 Outline 1 Related Literature 2 Small Open Economy Model with Labor Market Frictions Lama and Urrutia () Employment Protection August, / 38
27 Outline 1 Related Literature 2 Small Open Economy Model with Labor Market Frictions 3 Quantitative Analysis: Lama and Urrutia () Employment Protection August, / 38
28 Outline 1 Related Literature 2 Small Open Economy Model with Labor Market Frictions 3 Quantitative Analysis: 3.a. Business Cycle Properties Lama and Urrutia () Employment Protection August, / 38
29 Outline 1 Related Literature 2 Small Open Economy Model with Labor Market Frictions 3 Quantitative Analysis: 3.a. Business Cycle Properties 3.b. Firing Costs and Business Cycles Lama and Urrutia () Employment Protection August, / 38
30 Outline 1 Related Literature 2 Small Open Economy Model with Labor Market Frictions 3 Quantitative Analysis: 3.a. Business Cycle Properties 3.b. Firing Costs and Business Cycles 3.c. The Great Recession Lama and Urrutia () Employment Protection August, / 38
31 Outline 1 Related Literature 2 Small Open Economy Model with Labor Market Frictions 3 Quantitative Analysis: 3.a. Business Cycle Properties 3.b. Firing Costs and Business Cycles 3.c. The Great Recession 4 Concluding Remarks Lama and Urrutia () Employment Protection August, / 38
32 1. Related Literature 1 Closed Economy Models: Andolfatto (1996), Den Haan et al. (2000), Lagos (2006), Merz (1995), and Mortensen and Pissarides (1994). Lama and Urrutia () Employment Protection August, / 38
33 1. Related Literature 1 Closed Economy Models: Andolfatto (1996), Den Haan et al. (2000), Lagos (2006), Merz (1995), and Mortensen and Pissarides (1994). 2 Open Economy Models: Boz et al. (2009), Christiano (2007), Gourinchas (1998). Hairault (2002). Lama and Urrutia () Employment Protection August, / 38
34 2. Small Open Economy Model with Labor Market Frictions Canonical Small Open Economy Model following Mendoza (1991). Lama and Urrutia () Employment Protection August, / 38
35 2. Small Open Economy Model with Labor Market Frictions Canonical Small Open Economy Model following Mendoza (1991). Labor market frictions: Search, endogenous separation, ring and hiring costs. Lama and Urrutia () Employment Protection August, / 38
36 2. Small Open Economy Model with Labor Market Frictions Canonical Small Open Economy Model following Mendoza (1991). Labor market frictions: Search, endogenous separation, ring and hiring costs. Representative household: Pool income of members and thus provide insurance against unemployment. Lama and Urrutia () Employment Protection August, / 38
37 2. Small Open Economy Model with Labor Market Frictions Canonical Small Open Economy Model following Mendoza (1991). Labor market frictions: Search, endogenous separation, ring and hiring costs. Representative household: Pool income of members and thus provide insurance against unemployment. Focus on the extensive margin. Lama and Urrutia () Employment Protection August, / 38
38 2. Small Open Economy Model with Labor Market Frictions Canonical Small Open Economy Model following Mendoza (1991). Labor market frictions: Search, endogenous separation, ring and hiring costs. Representative household: Pool income of members and thus provide insurance against unemployment. Focus on the extensive margin. Social Planner Solution: Abstract from the wage setting process. Lama and Urrutia () Employment Protection August, / 38
39 2. Small Open Economy Model with Labor Market Frictions Canonical Small Open Economy Model following Mendoza (1991). Labor market frictions: Search, endogenous separation, ring and hiring costs. Representative household: Pool income of members and thus provide insurance against unemployment. Focus on the extensive margin. Social Planner Solution: Abstract from the wage setting process. Shocks: Technology and Interest Rates. Lama and Urrutia () Employment Protection August, / 38
40 Households E 0 β t t=0 i 1 hc t ϕ L1+ν t 1+ν 1 σ σ Non-separability between consumption and leisure. Lama and Urrutia () Employment Protection August, / 38
41 Households E 0 β t t=0 i 1 hc t ϕ L1+ν t 1+ν 1 σ σ Non-separability between consumption and leisure. No wealth e ects on labor supply. Lama and Urrutia () Employment Protection August, / 38
42 Households E 0 β t t=0 i 1 hc t ϕ L1+ν t 1+ν 1 σ σ Non-separability between consumption and leisure. No wealth e ects on labor supply. Interpretation: home production. Lama and Urrutia () Employment Protection August, / 38
43 Production 1 Intermediate Good: Produced with Labor. Lama and Urrutia () Employment Protection August, / 38
44 Production 1 Intermediate Good: Produced with Labor. 2 Final Good: Produced with Capital and Intermediate Goods with a Technology A t. Lama and Urrutia () Employment Protection August, / 38
45 Intermediate Goods 1 Continuum of jobs or matches between one rm and one worker. Lama and Urrutia () Employment Protection August, / 38
46 Intermediate Goods 1 Continuum of jobs or matches between one rm and one worker. 2 Jobs are indexed by a labor e ciency shock ω, hence each job produces ω units of output. Lama and Urrutia () Employment Protection August, / 38
47 Intermediate Goods 1 Continuum of jobs or matches between one rm and one worker. 2 Jobs are indexed by a labor e ciency shock ω, hence each job produces ω units of output. 2.a. ω is a random variable independently distributed over time with distribution function G. Lama and Urrutia () Employment Protection August, / 38
48 Intermediate Goods 1 Continuum of jobs or matches between one rm and one worker. 2 Jobs are indexed by a labor e ciency shock ω, hence each job produces ω units of output. 2.a. ω is a random variable independently distributed over time with distribution function G. 2.b. We assume a Pareto distribution for idiosyncratic shocks: ω σω G (ω) = 1 ω. Lama and Urrutia () Employment Protection August, / 38
49 Intermediate Goods 1 Continuum of jobs or matches between one rm and one worker. 2 Jobs are indexed by a labor e ciency shock ω, hence each job produces ω units of output. 2.a. ω is a random variable independently distributed over time with distribution function G. 2.b. We assume a Pareto distribution for idiosyncratic shocks: ω σω G (ω) = 1 ω. 3 After observing the shocks at the beginning of the period, the planner can decide to destroy a job if the labor e ciency is too low. Lama and Urrutia () Employment Protection August, / 38
50 Intermediate Goods 1 Continuum of jobs or matches between one rm and one worker. 2 Jobs are indexed by a labor e ciency shock ω, hence each job produces ω units of output. 2.a. ω is a random variable independently distributed over time with distribution function G. 2.b. We assume a Pareto distribution for idiosyncratic shocks: ω σω G (ω) = 1 ω. 3 After observing the shocks at the beginning of the period, the planner can decide to destroy a job if the labor e ciency is too low. 3.a. Endogenous threshold level ˆω t depending on the aggregate state of the economy. Lama and Urrutia () Employment Protection August, / 38
51 Intermediate Goods Lama and Urrutia () Employment Protection August, / 38
52 Intermediate Goods Z M t = L t ˆω t dg (ω t ) 1 G ( ˆω t ) dω t = Γ ( ˆω t ) 1 G ( ˆω t ) L t The higher the cut-o ˆω t. Lama and Urrutia () Employment Protection August, / 38
53 Intermediate Goods Z M t = L t ˆω t dg (ω t ) 1 G ( ˆω t ) dω t = Γ ( ˆω t ) 1 G ( ˆω t ) L t The higher the cut-o ˆω t. the higher the level of job destruction. Lama and Urrutia () Employment Protection August, / 38
54 Intermediate Goods Z M t = L t ˆω t dg (ω t ) 1 G ( ˆω t ) dω t = Γ ( ˆω t ) 1 G ( ˆω t ) L t The higher the cut-o ˆω t. the higher the level of job destruction. the higher the average productivity in the production of intermediate inputs. Lama and Urrutia () Employment Protection August, / 38
55 Intermediate Goods Z M t = L t ˆω t dg (ω t ) 1 G ( ˆω t ) dω t = Γ ( ˆω t ) 1 G ( ˆω t ) L t The higher the cut-o ˆω t. the higher the level of job destruction. the higher the average productivity in the production of intermediate inputs. This will typically occur in a recession. Lama and Urrutia () Employment Protection August, / 38
56 Final Goods Combines capital and intermediate good with a technology level A t Y t = A t (K t ) α (M t ) 1 α Aggregate production function can be rewritten " # Γ ( ˆωt ) 1 α Y {z} t = A t (K t ) α (L t ) 1 α 1 G ( ˆω t ) GDP {z } TFP Higher job destruction is associated with higher measured TFP. Lama and Urrutia () Employment Protection August, / 38
57 Labor Markets Labor ows: L t = L t 1 + H t S t Matching function (Hirings): H t = D (U t ) θ (V t ) 1 θ Separations: S t = G ( ˆω t ) [L t 1 + H t ] Lama and Urrutia () Employment Protection August, / 38
58 Closing the Model Feasibility: Y t = C t + I t + NX t + ηv t + κs t B t+1 = (1 + r t ) B t NX t Posting a Vacancy (V t ) entails a cost η, while a separation (S t ) a cost κ. Law of motion of capital: ϑ It K t+1 = (1 δ) K t + I t 2 K t 2 δ K t Labor endowment allocation: L t + U t = 1 Lama and Urrutia () Employment Protection August, / 38
59 Shocks log (A t ) = ρ A log (A t 1 ) + ε A t, log (1 + i t ) = ρ i log (1 + i t 1) + (1 ρ i ) log (1 + i ) + ε i t. Lama and Urrutia () Employment Protection August, / 38
60 Social Planner Solution: Selection E ect. π t (ω) = pt M ω ϕlt ν λ U t /λ C t Z +βe t λ C t+1/λ C t max π t+1 ω 0, κ dg ω 0. Social value of a standing job: expected present value of the output generated by the job net of the shadow price of an unmatched worker Lama and Urrutia () Employment Protection August, / 38
61 Social Planner Solution: Selection E ect. π t (ω) = pt M ω ϕlt ν λ U t /λ C t Z +βe t λ C t+1/λ C t max π t+1 ω 0, κ dg ω 0. Social value of a standing job: expected present value of the output generated by the job net of the shadow price of an unmatched worker The planner destroys jobs such that π t (ω) < κ. Lama and Urrutia () Employment Protection August, / 38
62 Social Planner Solution: Selection E ect. π t (ω) = pt M ω ϕlt ν λ U t /λ C t Z +βe t λ C t+1/λ C t max π t+1 ω 0, κ dg ω 0. Social value of a standing job: expected present value of the output generated by the job net of the shadow price of an unmatched worker The planner destroys jobs such that π t (ω) < κ. Monotonicity of π t in ω implies that the optimal rule is to shred jobs with ω < ˆω t, where ˆω t satis es π t ( ˆω t ) = κ. Lama and Urrutia () Employment Protection August, / 38
63 Social Planner Solution: Selection E ect. π t (ω) = pt M ω ϕlt ν λ U t /λ C t Z +βe t λ C t+1/λ C t max π t+1 ω 0, κ dg ω 0. Social value of a standing job: expected present value of the output generated by the job net of the shadow price of an unmatched worker The planner destroys jobs such that π t (ω) < κ. Monotonicity of π t in ω implies that the optimal rule is to shred jobs with ω < ˆω t, where ˆω t satis es π t ( ˆω t ) = κ. A higher ring cost will imply a lower cut-o ˆω t, hence less job destruction and lower measured TFP. Lama and Urrutia () Employment Protection August, / 38
64 Social Planner Solution: Selection E ect. Lama and Urrutia () Employment Protection August, / 38
65 Selection E ect: Labor Flows in Mexico. Table 2: Transitions between Occupational Status and Selection E ect in Mexico Employed! Unemployed Self-Employed! Unemployed percent selection percent selection Employed! Out Labor Force Self-Employed! Out Labor Force percent selection percent selection Source: Own elaboration using Encuesta Nacional de Empleo Urbano (ENEU), sample from 1988:Q1 to 1999:Q4. Lama and Urrutia () Employment Protection August, / 38
66 Diagnostic of Labor Market Frictions TFP or productivity wedge: TFP = Y t F (K t, L t ) Can be interpreted as the level of technological e ciency in the use of inputs (Solow residual). Labor wedge: Labor Wedge U l (C t, L t ) /U c (C t, L t ) A t F L (K t, L t ) Can be interpreted as the size of the distortion in the labor market required for the optimality condition (consumption/leisure choice) to hold. Lama and Urrutia () Employment Protection August, / 38
67 3. Quantitative Analysis: Calibration Table 3: Parameters for the Baseline Economy Parameter Symbol Value From Outside the Model Discount Factor β 0.99 World average Interest Rate i 1/β 1 Depreciation Rate δ 1.25% Capital Share α 0.3 Curvature Pareto Distribution σ ω 1.5 Persistence of Exogenous Productivity Shock ρ A 0.95 Frisch Elasticity of Labor Supply 1/ν 2.65 Elasticity of Matching Function θ 0.40 Hiring Cost η 0.1 Lama and Urrutia () Employment Protection August, / 38
68 3. Quantitative Analysis: Calibration Table 3: Parameters for the Baseline Economy Parameter Symbol Value Calibrated to Steady State Statistics Disutility of Labor ϕ 6.39 E ciency of Matching Function D 0.67 Scale of Pareto Distribution ω 0.99 Estimated from EMBI Data for Mexico S.D. of World Interest Rate σ i 1.37% Persistence of World Interest Rate ρ i 0.96 Calibrated to Business Cycle Volatilities S.D. of Exogenous Productivity Shock σ A 1.14% Covariance Interest Rate and Productivity Shocks σ A,i Firing Cost κ 3.90 Adjustment Cost of Capital ϑ 65 Lama and Urrutia () Employment Protection August, / 38
69 3. Quantitative Analysis: Business Cycle Properties Table 4: Business Cycle Statistics: Data and Model Data Mexico Baseline Model No i shock σ(y) σ(l)/σ(y) σ(i)/σ(y) Corr(1 + i, y) σ(c)/σ(y) Corr(nx/y, y) σ(tfp) Corr(tfp, y) Corr(l, y) σ(lwedge) Corr(lwedge, y) Lama and Urrutia () Employment Protection August, / 38
70 3. Quantitative Analysis: Firing Costs and Business Cycles 0.2 (a) Productivity Shock 0.2 (b) Measured TFP 0.5 (c) GDP % dev. from SS % dev. from SS % dev. from SS (d) Employment 10 (e) Hirings 20 (f) Separations % dev. from SS % dev. from SS 0 5 % dev. from SS (g) Labor Wedge 0.6 (h) Consumption 0.5 (i) Investment % dev. from SS % dev. from SS % dev. from SS High Firing Costs Low Firing Costs Lama and Urrutia () Employment Protection August, / 38
71 3. Quantitative Analysis: Firing Costs and Business Cycles Table 5: Separation Costs and Business Cycle Statistics Mexico Model: κ 4 Model: κ 1 σ(y) σ(tfp) σ(l) σ(l)/σ(y) σ(lwedge) Corr(lwedge, y) σ(c)/σ(y) Corr(nx/y, y) Lama and Urrutia () Employment Protection August, / 38
72 3. Quantitative Analysis: Firing Costs and Business Cycles Table 5: Separation Costs and Business Cycle Statistics Mexico Model: κ 4 Model: κ 1 Canada σ(y) σ(tfp) σ(l) σ(l)/σ(y) σ(lwedge) Corr(lwedge, y) σ(c)/σ(y) Corr(nx/y, y) Lama and Urrutia () Employment Protection August, / 38
73 3. Quantitative Analysis: The Great Recession 105 Consumption 110 Investment IV 08 II 08 IV 09 II 09 IV 10 II IV 08 II 08 IV 09 II 09 IV 10 II 105 Employment 105 Total Factor Productivity IV 08 II 08 IV 09 II 09 IV 10 II IV 08 II 08 IV 09 II 09 IV 10 II 110 Labor Wedge Model Data IV 08 II 08 IV 09 II 09 IV 10 II Lama and Urrutia () Employment Protection August, / 38
74 3. Quantitative Analysis: The Great Recession 105 GDP 102 Total Factor Productivity IV 08 II 08 IV 09 II 09 IV 10 II IV 08 II 08 IV 09 II 09 IV 10 II 105 Employment 200 Separations IV 08 II 08 IV 09 II 09 IV 10 II IV 08 II 08 IV 09 II 09 IV 10 II 103 Labor Wedge High Firing Costs Low Firing Costs IV 08 II 08 IV 09 II 09 IV 10 II Lama and Urrutia () Employment Protection August, / 38
75 The Great Recession: Canada vs. Mexico. 105 GDP 105 Employment IV 08 II 08 IV 09 II 09 IV 10 II IV 08 II 08 IV 09 II 09 IV 10 II 105 Consumption 110 Investment IV 08 II 08 IV 09 II 09 IV 10 II IV 08 II 08 IV 09 II 09 IV 10 II 105 Total Factor Productivity 110 Labor Wedge IV 08 II 08 IV 09 II 09 IV 10 II IV 08 II 08 IV 09 II 09 IV 10 II Mexico Canada Lama and Urrutia () Employment Protection August, / 38
76 Sensitivity Analysis Table 6: Sensitivity Analysis for the Mexican 2008 Great Recession Episode Baseline model Frisch Elasticity Curvature Pareto (1/ν 2.6, σ ω =1.5) 1/ν = 1 1/ν = 0.1 σ ω = 1.1 σ ω = 2 y l tfp Baseline model Matching Elasticity Capital Share (θ=0.4,α=0.3) θ = 0.2 θ = 0.6 α = 0.25 α = 0.4 y l tfp Lama and Urrutia () Employment Protection August, / 38
77 4. Conclusions Labor market institutions account for di erences in business cycles between developed and emerging economies. Lama and Urrutia () Employment Protection August, / 38
78 4. Conclusions Labor market institutions account for di erences in business cycles between developed and emerging economies. Endogenous selection provides a mechanism that mitigates the impact of negative shocks on output and productivity. Employment protection works against this mechanism. Lama and Urrutia () Employment Protection August, / 38
79 4. Conclusions Labor market institutions account for di erences in business cycles between developed and emerging economies. Endogenous selection provides a mechanism that mitigates the impact of negative shocks on output and productivity. Employment protection works against this mechanism. Extensions: Tradable vs. Non-tradable, Europe vs. U.S. Lama and Urrutia () Employment Protection August, / 38
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