This paper studies the effect of labor market reform on the welfare costs of business cycles. It develops a tractable search model with idiosyncratic labor market risk and risk-averse workers, and derives a convenient formula for the welfare cost of business cycles. The theoretical analysis shows that an increase in labor market flexibility reduces the welfare costs of business cycles. The paper also provides a quantitative analysis of the German labor market reforms of 2003-2005, the so-called Hartz reforms, which reduced unemployment benefits for the long-term unemployed and increased matching efficiency through improvements in job
placement services. The quantitative analysis suggests that the German labor market reforms of 2003-2005 reduced the welfare cost of business cycles by 20− 40 percent depending on the social welfare weights.