Employment protection, temporary and permanent employment share, and procyclicality of labour productivity

Using data from 32 Organisation for Economic Co‐operation and Development (OECD) countries, we find that the extent of the procyclicality of average labour productivity (ALP) differs significantly across countries, and is positively correlated with the strictness of employment protection. To account for this salient feature, we build up a theoretical model in which aggregate employment is divided into temporary and permanent categories; the two groups of employment are highly substitutable in production and the latter is subject to firing costs. Our numerical results suggest that in our model the intensity of labour firing costs, which characterizes the strictness of employment protection in OECD countries, has positive effects on both the procyclicality of ALP and the share of temporary employment. Moreover, considering the possibility of hiring different types of workers as short‐term substitutes contributes to a reduction in the relative volatility between output and aggregate hours worked, and hence a sharp decline in the procyclicality of ALP. The model can also explain why, with a higher intensity of labour firing costs, a firm has more incentives to hoard less productive redundant workers when the economy experiences a negative total factor productivity shock.