Technology-Policy Interaction in Frictional Labor Markets∗

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. ∗This paper was previously entitled “Vintage Capital In Frictional Labor Markets” and it is a substantially revised version of the Federal Reserve Bank of Richmond Working Paper 02-2, “Vintage Capital as an Origin of Inequalities.” Krusell thanks the NSF. Violante thanks the CV Starr Center for research support and the Federal Reserve Bank of Minneapolis for its hospitality. We are grateful to the editor and referees for helpful comments, and Glenda Quintini for providing the data on vacancies in OECD countries. Any opinions expressed are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of Richmond or the Federal Reserve System. For correspondence, our e-mail addresses are: [email protected], [email protected], and [email protected]. †Federal Reserve Bank of Richmond. ‡University of Rochester, Institute for International Economic Studies, CAERP, CEPR, and NBER. §New York University, and CEPR.