Bank of Lithuania

Labour market institutions in open economy


This paper builds a theoretical model that introduces frictional unemployment in a two-sector multi-worker heterogeneous firms model with a dynamic matching process. In doing so, we have a rich environment that combines product, labour, and international markets. A change in labour market policies (unemployment benefits and employment contingent subsidies) transforms the share of exporters and affects average productivity. Empirical evidence confirms a robust positive effect of employment subsidies on openness, little, if any, impact of subsidies and a positive effect of replacement rate on unemployment. Closure of equilibrium plays an important role to explain data facts about employment subsidies: using sectoral arbitrage condition, subsidies cease affecting unemployment and make openness grow, consistently with the empirical evidence. Unemployment benefits, on the other hand, make unemployment and openness rise, independently of sectoral reallocations. In addition, we find that unemployment benefits bear different policy implications with regards to international coordination than employment subsidies.

JEL Codes: E24, F12, F16.

The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.

labour market institutions, heterogeneous multi-worker firms, dynamic matching, openness