How Might We Expect the Labour Market to Respond to Shocks?

Over the past two years, the world economy has been subjected to two large economic shocks that have left most of the world’s economies in recession:  the reduction in the ability of the financial system to intermediate between lenders and borrowers, and a large fall in world trade, only partly a direct result of the fall in world output. Our objective in this paper is to use macroeconomic models to analyse how we might expect labour market variables - nominal and real wage growth, employment and unemployment - in the Euro Area and other European economies to respond to these shocks, and what implications these wage and employment dynamics may have for inflation and monetary policy.

To analyse these issues, we use a combination of two models: a closed-economy for the Euro Area as a whole and a small open-economy model for a single country within or outside the eurozone. We apply the second model to three individual countries that differ in their labour market characteristics and monetary frameworks: Estonia, Hungary and the United Kingdom. Estonia is a small open economy with flexible labour markets, which operates a currency board.  Hungary is a small open economy with sizeable nominal wage rigidity and an inflation-targeting monetary policy regime. Finally, the United Kingdom is a large open economy with flexible labour markets and an inflation-targeting monetary policy regime.

In each case, we model the financial intermediation shock as a shock to the ‘risk premium’, i.e., the wedge between the official interest rate and the interest rate that consumers consider when making their consumption vs. savings decisions.  For the open economies we also consider external risk premium shocks, because in small open economies the ‘credit crunch’ partly originated from outside these countries. In the closed-economy setup, we model the drop in world trade as a shock to exogenous demand within the economy; in the open-economy case, it is a shock to the exogenous demand for the economy’s exports.

For the Euro Area as a whole, we first obtain some baseline impulse responses and then ask how these responses would change with changes to the degrees of nominal and real wage rigidity, the degree to which the wages of newly-hired workers are flexible, the degree of employment rigidity, and the monetary policy response.  For our individual countries we obtain some impulse responses and compare them across the countries. The idea is to relate differences in the responses of labour market and other macro variables to differences in the degrees of nominal and real wage rigidity, the degree of employment rigidity, and monetary policy regime across countries.