Labor market policies in high- and low-interest rate environments: Evidence from the euro area

Do labor market policies initiated in periods of loose monetary policy yield different outcomes from those introduced when monetary tightening prevails? Using data from 11 euro-area members up to 2010 – and extending to 17 countries up to 2020 – we analyze three labor market policies: replacement rates, spending on active labor market policies (ALMPs), and employment protection. We find that these policies deliver different macroeconomic outcomes in low- and high-interest rate environments. In particular, ALMPs reduce unemployment if implemented under a loose monetary policy but not otherwise, whereas higher employment protection delivers expansionary effects under a tight monetary policy. These findings highlight that the effectiveness of labor market policies is significantly influenced by the monetary policy environment, emphasizing the need for coordinated policy design. Methodologically, we contribute by proposing to average local projections using Mallow’s Cp criterion, allowing for inferences that are robust to mis-specification and accommodate non-linearities. •Labor policies’ outcomes vary with monetary policy stance.•Unemployment benefits deflate initially but can inflate in the medium term.•ALMPs reduce unemployment more under loose monetary policy.•EPL is inflationary during tightening but reduces unemployment.•Local projections averaged by Mallow’s criterion provide robust dynamic policy responses.