Fixed Term Employment Contracts in an Equilibrium Search Model
Fixed term employment contracts have been introduced in number of European countries as
a way to provide flexibility to economies with high employment protection levels. We introduce
these contracts into the equilibrium search model in Alvarez and Veracierto (1999), a version
of the Lucas and Prescott island model, adapted to have undirected search and variable labor
force participation. We model a contract of length J as a tax on separations of workers with
tenure higher than J . We show a version of the welfare theorems, and characterize the efficient
allocations. This requires solving a control problem, whose solution is characterized by two
dimensional inaction sets. For J = 1 these contracts are equivalent to the case of firing taxes,
and for large J they are equivalent to the laissez-faire case. In a calibrated version of the
model, we evaluate to what extent contract lengths similar to those observed in Europe, close
the gap between these two extremes.
