– The purpose of this paper is to compare two elements of lay-off costs in a dynamic model of the labor market and analyze the differences for business cycle dynamics and welfare.
– The paper builds a general equilibrium Real Business Cycle model and introduces firing costs and severance payments. Labor market frictions are assumed to follow the famous search and matching approach.
– The paper finds that firing costs imply a higher volatility over the cycle and have stronger negative welfare effects. Severance payments have a lower volatility, reduce unemployment, and reduce welfare by a smaller amount.
– Policy reforms should be aimed to use severance payments and reduce the ring cost component of lay-off costs.
– Increasing welfare and a more stable business cycle could be supported by using severance payments instead of firing costs.
