Labor Markets and Business Cycles
Princeton University Press (2010)

This book was originally prepared for the CREI Lectures in Macroeconomics, which I gave at Universitat Pompeu Fabra in Barcelona on June 17-19, 2008.  The book consolidates and extends existing results on the role of search frictions and wage rigidities in explaining the cyclical dynamics of labor markets.

I focus particularly on the behavior of the labor wedge, the wedge between the marginal rate of substitution of consumption for leisure and the marginal product of labor.  According to competitive models, the labor wedge should be constant over the business cycle.  In the data, it is strongly countercyclical.  Thus, through the lens of a competitive labor market model, it looks as if recessions are periods when workers are dissuaded from working and firms are dissuaded from hiring workers because of an increase in the labor income tax rate.  

I then ask whether search frictions can help to explain the behavior of the labor wedge.  I show that, if wages are set by Nash bargaining between workers and firms, search frictions act like a labor adjustment cost and reduce the volatility of employment.  If such a model were the data generating process, a frictionless model with a constant labor wedge would predict more than the observed fluctuations in employment.  To rationalize the data, the labor wedge would be strongly procyclical, the opposite of what we observe in the data.

Finally, I show why wage rigidities may be able to reconcile the search model with the behavior of the labor wedge.  In the presence of search frictions, wage rigidities can amplify fluctuations in the probability that an unemployed worker finds a job.  I show that this type of amplification is in line with the behavior of the labor market along several dimensions.

Much of this material is based upon work supported by the National Science Foundation under Grants 9709881, 0079345, and 0351352 and 0648842. Any opinions, findings, and conclusions or recommendations expressed in this material are those of the author(s) and do not necessarily reflect the views of the National Science Foundation.