Employment protection and the stock market: the common shock case

This paper considers the consequences of employment protection with a fully diversified stock arket when firms face a common shock. The analysis focuses on the interaction between employment protection and the stock market when wages are sluggish or fixed. We build and calibrate a dynamic model where firms decide upon capital utilization, investment, vacancy posting and layoffs in order to maximize shareholder value. Public policy, devoted to employment protection, is parameterized through firing costs. Due to the capital and employment irreversibilities, the model has to be solved using numerical techniques. Two series of scenarios are presented, first considering the effect of alternative level of firing costs in a benchmark economy, thus examining interactions between firing cost and successively, (i) higher market price of risk, (ii) higher separation rates, (iii) fixed wages, (iv) fixed capital utilization and (v) alternative cyclical features.