Foreign labor costs and domestic employment: What are the spillovers?

This paper studies the international spillover effects of country-specific labor cost changes in the presence of labor market frictions. A two-country model with search frictions predicts that a cut in foreign labor costs leads to an increase in domestic employment, driven by a positive terms of trade effect on job creation. I find empirical evidence in support of this positive spillover effect, the terms of trade channel, and the dependence on the degree of labor market rigidity. This is done by a panel regression that estimates the effect of exogenous variation in foreign unit labor costs, instrumented by changes in foreign statutory social security contribution rates, on domestic employment and output.