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Working Papers

November 2006, No. 06-10

Technology-Policy Interaction in Frictional Labor Markets

Andreas Hornstein, Per Krusell and Giovanni L. Violante

(WP 06-10 replaces an earlier version listed as WP 02-2)

Does capital-embodied technological change play an important role in shaping labor market outcomes? To address this question, we develop a model with vintage capital and search-matching frictions where irreversible investment in new vintages of capital creates heterogeneity in productivity among firms, matched as well as vacant. We demonstrate that capital-embodied technological change reduces labor demand and raises equilibrium unemployment and unemployment durations. In addition, the presence of labor market regulation—we analyze unemployment benefits, payroll and income taxes, and firing costs—exacerbates these effects. Thus, the model is qualitatively consistent with some key features of the European labor market experience, relative to that of the United States: it features a sharper rise in unemployment and a sharper fall in the vacancy rate and the labor share. A calibrated version of our model suggests that this technology-policy interaction could explain a sizeable fraction of the observed differences between the United States and Europe.