Why are workers unemployed sometimes? Why do unemployed workers coexist with job vacancies? How much does the incidence and the duration of unemployment rise during economic downturns, and why? Much of my research during the last five years has tried to answer these questions by developing quantitative models of labor market dynamics and comparing the models' predictions with data, especially from the United States.
Lucas and Rapping's theory of intertemporal substitution in labor supply is the starting point for any modern analysis of employment fluctuations, (1) including the real business cycle model (2) and the New Keynesian model. (3) The key assumption is that workers decide how much to work at each point in time, taking the prevailing wage as given. To the extent that labor supply is elastic, hours of work fluctuate with movements in the wage.
While models based on intertemporal substitution are qualitatively consistent with the movement of hours of work over the business cycle, they run into at least two problems. First, a number of authors have argued that, from the perspective of a labor-market-clearing model, hours of work fluctuate too much at business cycle frequencies. Recessions look like times when the disutility of work increases. Equivalently, they look like times when labor income taxes rise, discouraging workers from supplying labor. (4) Neither possibility is empirically tenable. Second, models where workers can decide how much to work at each point in time can generate movements in hours worked but do not generate unemployment, that is, non-employed workers who would like to work at the prevailing wage. This omission may have important implications for welfare, because workers who cannot find jobs at the prevailing wage but would like to have them are, by revealed preference, worse off than if they simply chose not to work at that wage. It also may have important consequences for the positive analysis of business cycles, because most cyclical movements in aggregate hours of work are explained by movements between employment and unemployment, not by movements in hours worked by employed workers.
Equilibrium search and matching models provide an ideal laboratory for understanding unemployment. (5) These models build on the idea that it takes workers time to find a job. Thus a worker entering the labor market, or a worker who loses her job, necessarily experiences a spell of unemployment. Moreover, unemployed workers are worse off than employed workers because they cannot work until they find a job. In this sense, this is a theory of unemployment, not just of non-employment.
Search and matching models also assume that firms must create job vacancies in order to find a suitable worker. A matching function determines the number of workers and firms that meet as a function of the unemployment and vacancy rates. Because of the frictions embodied in the matching function--the number of matches is smaller than either the number of unemployed workers or the number of vacancies--unemployed workers and vacant jobs necessarily coexist.
Fluctuations in the profitability of hiring a worker, possibly because of fluctuations in aggregate productivity, induce fluctuations in the number of job vacancies. When firms create more job vacancies, unemployed workers find jobs faster, pulling down the unemployment rate. Thus search and matching models naturally generate a negative correlation between the unemployment and vacancy rates, a robust feature of U.S. data. (6) The extent of the movement in unemployment and vacancies is limited by the behavior of wages, which many authors assume are bargained bilaterally between workers and firms. As firms create more jobs, workers grow less concerned with the risk of unemployment. This improves their threat point in bargaining, allowing them to obtain a higher wage. This, together with the reduced availability of labor, limits firms' willingness to create jobs and restores the economy to equilibrium. …