Negative Shocks, Job Creation, and Selection. WWWforEurope Working Paper No. 11

High inter-country variability characterises the responsiveness of both output to (exogenous) shocks and employment to output contractions. We argue that inter-country differences in firm-size distributions contribute to explaining this variability. Within an open economy model, we show that competitive selection processes are an important channel through which a shock affects aggregate employment. Intra-industry selection is then shown to influence the effectiveness of active labour market policies in countering the employment and welfare effects of a negative shock. We estimate a measure of the shape parameter of firm size distribution and study its effect on the employment-output relationship for a number of OECD countries. Our results confirm the key predictions of the theory.