The EU-US Unemployment Puzzle Revisited: Institutions, Demography, and Capital Flows

The historical evolution of the EU-US unemployment rate gap is often explained
in the literature in terms of asymmetric changes in labour market institutions. Population
aging is another potential source of asymmetry. Asymmetric population
aging may generate international capital flows and have a substantial impact on
relative unemployment rates. In this paper, we examine whether the combination
of institutions, aging and capital flows explains the rise in the gap between 1960
and 2010. To this end, we set up a two-region overlapping generation model with
search unemployment in which we introduce the historical and projected changes
in labour market institutions and demographic evolutions. We show that asymmetric
institutional changes alone can reproduce a large part of the historical rise in
the unemployment gap. However, this result does not hold anymore once we add
asymmetric aging in closed economies. We are nevertheless able to restore and even
improve the initial result when we allow for international capital mobility.