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This paper explores the influence of labor market institutions on aggregate fluctuations. It uses a dynamic, stochastic, general equilibrium model characterized by search and matching frictions in the labor market and nominal rigidities in the goods market. It finds that firing costs and unemployment benefits can have substantial effects on aggregate fluctuations. Increasing firing costs decreases the volatility of output, employment, and job flows due to the reduction in the mass of jobs sensitive to disturbances and lower incentives for firms to hire and fire workers. Hence, firms adjust to shocks mainly through prices, causing inflation to become more volatile. Raising unemployment benefits has the reverse effect on aggregate fluctuations.

Labor market institutions play an important role in the macroeconomic performance of an economy.1 In principle, the structure of the labor market influences the long-run equilibrium of an economy and therefore the way in which macroeconomic aggregates fluctuate over time. The literature extensively focuses on the impact of labor market institutions on the underlying structural features of the economy,2 but as detailed below, only a few papers have studied their impact on business cycle fluctuations. Of those, none has used a general equilibrium search and matching model of the labor market, nor have any of them incorporated nominal rigidities in the analysis.

This paper has analyzed the effects of labor market institutions on aggregate fluctuations. The analysis focused on firing costs and unemployment benefits in a DSGE framework characterized by search and matching frictions in the labor market and nominal rigidities in the goods market. Labor market institutions have significant effects on the structural features of the economy. Changes in labor market institutions alter the deep structure of the economy and hence, the way it reacts to disturbances. Firing costs lower the response of output, employment and job flows, while increasing that of inflation. Unemployment benefits produce reverse effects. It must be noted that the distribution of the idiosyncratic productivity shocks that firms face is important. Here, in line with empirical evidence and previous theoretical studies, the distribution is log-normal. Its calibration, as determined by the robustness analysis, is important in determining the precise quantitative effects of firing costs and unemployment benefits on aggregate fluctuations. Nonetheless, the qualitative results continue to hold for different calibrations of the log-normal distribution.