Working Paper no. 109
By Stephen P Millard
This paper uses the increase in labour market flexibility in the United Kingdom in recent years to see how well the predictions of a couple of recently developed labour market models can account for data. I am chiefly concerned with the flexibility to make wage and employment adjustments at the microeconomic (firm or plant) level. The two models I examine are an ‘equilibrium business cycle’ model of the labour market and a ‘search’ model. They predict that an increase in labour market flexibility will lead to an increase in output and consumption and a fall in unemployment and hours. They also predict that employment and unemployment will become less volatile. Since about 1985, the level and persistence of the unemployment rate have fallen, as predicted by the theory. But this has been accompanied by a fall in unemployment incidence and not much change in duration: the reverse of what we would have expected, given the theory. Average hours worked have fallen, as predicted by the theory. In terms of cyclical behaviour, we can note that the volatilities of output, consumption, employment and unemployment have all increased in the most recent cycle, though the volatility of hours worked relative to output has fallen, as suggested by the models. Finally, a graph of trend (HP-filtered) output and consumption reveals a ‘step jump’, which we could take as some evidence for the models (though we could imagine other plausible explanations for such a change).