Capital Flows, Incomplete Markets, and the U.S. European Unemployment Gap

This paper investigates the relationship of the ``unemployment gap'' between the United States and Europe to the opening of international capital markets. The unemployment gap widened dramatically in the mid-1980's, a time period characterized also by significant increases in international capital flows--including substantial flows from Europe to the U.S.. The implications of capital mobility for unemployment levels and current accounts are studied in a multi-country dynamic model with incomplete international capital markets and national labor markets characterized by search and matching. The economy also features unemployment insurance financed by distorting taxes on capital and labour income. It is shown that a given difference in the generosity of unemployment benefits leads to a larger difference in unemployment rates across countries when there is some international capital mobility than in financial autarky. Moreover, the long-run effects of an opening of capital markets include an increase in the unemployment rate and an outflow of capital for high unemployment benefit countries and a reduction in the unemployment rate coupled with an inflow of capital for low benefit countries. In addition to these permanent effects, an opening of capital markets may have persistent transition effects including larger short-run differences in unemployment rates across countries and current account imbalances. Quantitatively, our model accounts for a significant share of the relative changes in both unemployment rates and international asset positions for the U.S. and several European countries since the mid-1980