Labour dynamics in macro models

Labour dynamics in macro models
Shock transmission through labour markets

Ekkehard Ernst1

1
Employment Trends Unit
International Labour Organization
Geneva
ernste@ilo.org

http://ekkehard.ernst.free.fr

IMF
Apr 18th, 2012

E. Ernst (ILO) ILO Modelling Washington, 2012 1 / 27

Understanding growth and employment The traditional approach

The ILO Global Employment Trends approach

GET is based on a tight employment-growth link
Okun’s law as methodological background
Allows regional and country-specific employment projections
Useful for imputation of missing data

Employment by different labour market segments
Metholodolgy can be applied at the level of individual labour
market segments
Allows to differentiate for employment by:
Age
Gender
Sector
Status (self-employment, informal employment)


Understanding growth and employment A new method

Considering labour dynamics more closely

Unemployment is the result of labour flow dynamics
In the current crisis both unemployment in- and outflows explain
unemployment dynamics
Different factors help explain their movements ⇒analysis
necessary for precise policy recommendations
Characteristic patterns of both flow types over the business cycle

0.024
0.4

0.022
0.3

Job destruction rate
Job creation rate

0.020
0.2

0.018
0.1

0.016
0.0

1970 1980 1990 2000 2010

Job creation rate Job destruction rate
Note: No data available for Argentina, China, India, Indonesia and Saudi Arabia.
Shaded areas correspond to global recessions
Source: GET Labour flows model


Understanding growth and employment A new method

Labour flows and the business cycle

Okun’s law approach insufficient
In- and outflows are mutually dependent via employment stocks
Strong cyclical variations of coefficients make the traditional
approach impractical
Calls for integrating flows in a (small) macro model

Elasticitiy of job creation rates Elasticitiy of job destruction rates
(wrt. to GDP growth, time−varying) (wrt. to GDP growth, time−varying)
0.35

0.01
Pre−crisis peak (2008)

0.00
0.30
Coefficient estimate

Coefficient estimate
−0.01
0.25

−0.02
0.20

−0.03

Great recession (2009)
0.15

1970 1980 1990 2000 2010 1970 1980 1990 2000 2010

Confidence interval Time−varying estimate Confidence interval Time−varying estimate


Understanding growth and employment Overview of today’s talk

Overview

1 Modelling unemployment flows
Research strategy
What drives unemployment dynamics?

2 A macro “wrapper”
Modelling and estimation strategy
A finance-augmented double Phillips curve

3 Estimation and model dynamics
Data and methodology
Estimating the labour flow macro-model
Model dynamics under shocks

4 Shock transmission under different policy settings

5 Concluding remarks


Modelling unemployment flows Research strategy

Aiming at a fully estimated model

In the tradition of macro-econometric models
All parameters are estimated; no calibration
All variables are based on observables
Instrumentation of expectation variables

Including policy reaction functions
Taylor rule for monetary policy
Government spending rule for fiscal policy
Monetary-fiscal interactions via public debt



Model ideas I

Flow model of the labour market
Empirical formulation of standard matching model
Full and separate account of unemployment in- and
outﬂows
See, e.g., Carlsson et al. (2006)

Financial frictions model
Real-share prices aﬀect investment and long-term
interest rates (e.g., Phelps, 1994)
Yield curve with sticky long-term interest rates
Productivity shocks as medium-term drivers



Model ideas II

Wage-price dynamics
Double Phillips curve (e.g. Flaschel et al. 1997; Erceg
et al. 2000):
Reduced-form wage bargaining curve
Hybrid Phillips curve

Labour market policies interact with structural shocks
Use reduced-form strategies to model structural policies
Employment protection
Wage policies/bargaining institutions
Policy identiﬁcation through parameter changes


Modelling unemployment flows What drives unemployment dynamics?

An overview of the model flows I

Decomposing unemployment dynamics into...

Ut = Lt − ETt = INt − OUTt

...Labour force growth and...

Lt = α3 + β31 Lt −1 + β32 ut −1 + β33 Taxt

...Employment growth (i.e. the net effect of job creation and destruction)

ETt = JobCreationt − JobDestructiont



An overview of the model ﬂows II

Job creation

JobCreationt = β11 ETt −1 + β12 wt + β13 ADt + β14 rt + β15 Invt +
β16 JobCreationt −1

Job destruction

JobDestructiont = β21 TFPt + β22 rt + β23 REERt + β24 ADt + β25 wt +
β26 JobDestructiont −1

Wage determination:

wt = α4 + β41 Kt + β42 CBt + β43 ut −1 + β44 Taxt



Putting the pieces together

Substituting the ﬂow equations:

OUTt = JobCreationt
INt = JobDestructiont + ∆Lt −1

Hence:

OUTt = β11 OUTt −1 + β12 XtJobCreation + β14 ETt −1
INt = β21 INt −1 + β22 XtJobDestruction + β24 Lt −1


A macro “wrapper” Modelling and estimation strategy

Modelling methodology I
Step-by-step estimation

Step 1: Identify base-line equations
Macro variables to affect unemployment flows
Reduced-form panel estimates
System-GMM used to control for endogeneity
Results published in Ernst (2011)

Step 2: Identify relevant fiscal interactions
Labour flow model generically refers to aggregate demand
Possibility to set up specific fiscal interactions such as:
Wage- vs. Non-wage public consumption
Direct vs. indirect taxation
Labour market programmes (ALMP, UB)
Results published in Ernst and Rani (2011)

A macro “wrapper” Modelling and estimation strategy

Modelling methodology II

Step 3: Estimate macro model
Introduce macro-economic closure: Modiﬁed Euler equation
Introduce endogenous policy rules
Estimate using GMM

Step 4: Simulate model and reform scenarios
Model simulation using Dynare
Reform scenarios through parametric change
Analysis of shock transmission:
Financial shocks (share prices)
Productivity shocks
Analyse impact on unemployment dynamics


A macro “wrapper” A finance-augmented double Phillips curve

Financial frictions and labour flows

Share price dynamics
Financial accelerator effect due to variations in real share
prices, Ft
Gross-fixed capital formation also depends on public
investment and real long-term interest rates:

Kt = Kt −1 + Ft −1 + GtI−1 + LPt −1 + rtL 1
−

Yield curve
Wedge between long- and short-term interest rates
Short-term rates determined by household expectations and
policy interventions
Long-term rates with persistence determined by:
Share prices
Net government lending

A macro “wrapper” A finance-augmented double Phillips curve

A double Phillips curve

Price inflation
πt = πt −1 + E πt+1 + REERt −1 + Gapt −1

Wage inflation

wt = wt −1 + ETt −1 + πt −1 + E πt+1 + TFPt −1

Output gap dynamics

Gapt = wt + OUTt −1 + INt −1 + GovConst −1


Estimation and model dynamics Data and methodology

A word on the data and methodology

Unemployment flows come from Elsby et al. (2008)
Constructed on the basis of information regarding unemployment duration at
different duration lengths
Complemented by similar information for more years and other countries to
improve coverage
Extended coverage possible using imputation methods with broadly similar
results
Information on share price dynamics is based on OECD share price index
(OECD Main Economic Indicators) deflated by CPI
Macro indicators come from the OECD Economic Outlook database
Fixed effects have been accounted for through de-meaning:

dXit = Xit − Xi · + X··


Estimation and model dynamics Estimating the labour ﬂow macro-model

Estimation results: Labour block

INt−1 ∆LFPRt−1 ∆Prodt−1 RIRSt−1 TaxIndt−1 Gapt ∆Wagest−1
(1) INt 0.620*** -7.084*** -5.702*** 0.008*** 1.284*** -0.018*** 0.254***
(0.021) (0.901) (0.434) (0.001) (0.313) (0.001) (0.090)

OUTt−1 ETRt UCCt ∆Wagest ∆INVt Gapt
(2) OUTt 0.595*** 1.812*** -0.009*** -0.940*** 3.303*** 0.024***
(0.017) (0.140) (0.001) (0.122) (0.240) (0.001)

OUTt INt
(3) ∆ETt 0.015*** -0.019***
(0.001) (0.002)

∆Wagest−1 πt−1 E {πt+1 } ∆Prodt ∆ETt−1
(4) ∆Wagest 0.640*** 0.178** 0.045* 0.487*** 0.255***
(0.040) (0.031) (0.027) (0.082) (0.042)

∆Prodt−1 ∆TFPt−1
(5) ∆Prodt 0.751*** 0.033**
(0.065) (0.004)



Estimation results: Macro block

E {RIRSt+1 } GAPt NLGQt πt−1
(6) RIRSt 1.157*** 0.094*** -0.116*** -9.426***
(0.018) (0.021) (0.040) (1.384)

RSharet RIRLt−1 RIRSt
(7) RIRLt 0.700*** 0.419** 0.493***
(0.186) (0.012) (0.012)

RSharet−1 ∆GovInvt−1 ∆Prodt−1 RIRLt−1 ∆ETt−1
(8) INVt 0.004* 2.687*** 0.678*** -0.001*** 0.547***
(0.002) (0.921) (0.116) (0.000) (0.034)

OUTt−1 INt−1 ∆Wagest GovConst−1
(9) GAPt 1.090*** -4.390*** 4.971*** 8.062***
(0.131) (0.278) (1.357) (2.698)

πt−1 E {πt+1 } ∆ToTt−1 ∆Wagest−1
(10) πt 0.449*** 0.533*** -0.049*** 0.041
(0.018) (0.028) (0.014) (0.029)



Estimation results: Fiscal block

GovConst−1 ∆ETt−1
(11) GovConst 0.973*** 0.025*
(0.025) (0.015)

GovInvt−1 ∆ETt−1
(12) GovInvt 0.959*** 0.028***
(0.042) (0.007)

OUTt−1 INt−1
(13) Taxt 0.010*** 0.003
(0.001) (0.003)

GovConst GovInvt Taxt
(14) NLGQt -88.626*** -122.280*** 106.385***
(4.530) (9.230) (3.129)


Estimation and model dynamics Model dynamics under shocks

Unemployment and productivity shocks
Reduction in total factor productivity leads to...
Productivity growth Gross fixed capital formation
0 0.5

−0.2
0
−0.4
−0.5
−0.6

−0.8 −1
10 20 30 40 50 10 20 30 40 50

Unemployment Output gap
20 0

15
−20
10
−40
5

0 −60
10 20 30 40 50 10 20 30 40 50


Estimation and model dynamics Model dynamics under shocks

Transmission of ﬁnancial shocks
Adverse shock to real share prices and its eﬀect on the real economy
Unemployment Output gap
8 0

−2
6
−4
4
−6
2
−8

0 −10
10 20 30 40 50 10 20 30 40 50

Gross fixed capital formation Real wage growth
0 0

−1
−0.01
−2
−0.02
−3

−4 −0.03
10 20 30 40 50 10 20 30 40 50


Shock transmission under different policy settings

Policy change scenarios

How to model shifts in structural policies?
Structural model with reduced-form elements
Allows changes in certain parameters to be identified with policy changes:
Shock transmission on unemployment flows
Reactivity of wages to productivity shocks
Employment protection legislation...
...affect the level of unemployment flows, but this has no effect in our
linearized model
...also affect the elasticity of flows wrt shocks
Dynamic effects depend on the transmission margin that is affected most
Question: Why do some countries with high EPL seem to have suffered less
from financial crisis?
Wage policies/collective bargaining institutions
Minimum wages affect wage level⇒Level effects only
Collective bargaining affects elasticity of wages wrt productivity,
unemployment and inflation



Dynamic eﬀects of changes in EPL I
Higher EPL =⇒ weaker reaction of unemployment to adverse ﬁnancial shocks
6.0

5.0

e)
at
4.0
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e a
m 3.0 et
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ol s
p mo
m 2.0 f
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U oi
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ai
1.0 v
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d(
0

1 3 5 7 9 94 74 54 34 14 93 73 53 33 13 92 72 52 32 12 91 71 51 31 11

1.0-
secirp erahs laer ot kcohs retfa sraeY

Baseline Lower reactivity of flows to shocks after increasing EPL



Dynamic eﬀects of changes in EPL II
Decomposing shifts in unemployment dynamics: Biggest eﬀect stems from the
interest rate channel
10

5
Composition of changes in unemployment dynamics

0
1 6 11 16 21 26 31 36 41 46
Years after shock to real share prices

-5

-10

-15

-20

-25

-30

Interest rate transmission Output gap transmission Wage growth transmission
Investment transmission Total effect of reforms


Changes in the wage pass-through
Changes in the reactivity of wages have substantial eﬀects on the dynamics of
unemployment
0.015

0.01
Unemployment reaction to productivity shock

0.005
(Deviation from steady state)

0
1 6 11 16 21 26 31 36 41 46
kcohs ytivitcudorp esrevda retfa sraeY

-0.005

-0.01

-0.015
Baseline Lower reactivity of wages to employment conditions

Higher real wage rigidity Lower sensitivity of wages to inflation

Concluding remarks

Lessons learned and outlook

What have we learned so far?
Linear structural model allows full estimation of all parameters
Pass-through play important role for labour flows and unemployment
Allows detailed analysis of transmission mechanisms

Next steps
Labour flow data available for 60+ countries
Develop open economy and global model, based on estimation of regional
blocks
Country-specific pass-through effects rather than fixed effect
Allow for more direct policy interactions (include policy variables in the model
set-up)
Need more precise (empirical) information on flow elasticities wrt structural
policies


Bibliography

Bibliography
Carlsson, M.; Eriksson, S.; Gottfries, N. 2006. Testing Theories of Job
Creation: Does Supply Create Its Own Demand? Discussion Paper, No. 2024
(Bonn: Institute for the Study of Labor (IZA)).
Erceg, C. J.; Henderson, D. W.; Levin, A. T. 2000. "Optimal monetary
policy with staggered wage and price contracts", Journal of Monetary
Economics, Vol. 46, No. 2, pp. 281-313.
Ernst, E. 2011. Determinants of unemployment flows. Labour market
institutions and macroeconomic policies. Discussion paper, No. 209 (Geneva:
International Institute for Labour Studies), available at:
http://www.ilo.org/public/english/bureau/inst/download/dp209_2011.pdf
Ernst, E.; Rani, U. 2011. “Understanding unemployment flows”, Oxford
Review of Economic Policy, Volume 27, No. 2, pp. 268–294.
Flaschel, P.; Franke, R.; Semmler, W. 1995. Dynamic macroeconomics.
Instability, fluctuations, and growth in monetary economies. (Cambridge,
MA.: MIT Press).
Phelps, E. 1994. Structural Slumps. (Cambridge, MA.: Harvard University
Press).

Labour dynamics in macro models

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