This paper extends the seminal Blanchard and Katz regional market model include interaction effects using a dynamic spatial panel data approach. Three key contributions of this extended model are: (i) the unrealistic assumption that regions are independent of on another no longer has to be made, (ii) the magnitude and significance of so-called spillover effects can be empirically assessed, and (iii) both the temporal and spatial propagation of labo demand shocks can be investigated. Using annual data from 1986-2010 for 112 regions acro eight EU countries, both the non-spatial and spatial models are estimated. It is found that the majority of the spillover effects are highly significant. Consistent with economic theory, the impact of a region-specific demand shock is largest in the region where the shock instigate. The shock also propagates to other regions, especially impacting the first and second-ord neighbours.
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