Unemployment (Fears) and Deflationary Spirals

(with Wouter J. Den Haan and Pontus Rendahl, Journal of the European Economic Association (forthcoming))
(old version: CEPR Discussion Paper No. 10814, September 2015)

The interaction of incomplete markets and sticky nominal wages is shown to magnify business cycles even though these two features – in isolation – dampen them. During recessions, fears of unemployment stir up precautionary sentiments which induces agents to save more. The additional savings may be used as investments in both a productive asset (equity) and an unproductive asset (money). The rise in demand for the unproductive asset has important consequences. In particular, the desire to hold money puts deflationary pressure on the economy which, provided that nominal wages are sticky, increases labor costs and reduces firm profits. Lower profits repress the desire to save in equity, which increases (the fear of) unemployment, and so on. This is a powerful mechanism which causes the model to behave differently from its complete markets version. In our framework, the deflationary pressure yields a meanreverting reduction in the price level, which implies an increase in expected inflation and a decrease in the expected real interest rate even if the policy rate does not adjust. Thus, our mechanism is different from the one emphasized in the zero lower bound literature. Due to the deflationary spiral our model also behaves differently from its incomplete market version without aggregate uncertainty, especially in terms of the impact of unemployment insurance on average employment levels.

The Impact of Uncertainty Shocks on the Job-Finding Rate and Separation Rate

Increases in uncertainty lead to increases in the unemployment rate. Using US data, I show empirically that this is due to both an increase in the separation rate and a decrease in the job-finding rate. By contrast, standard search and matching models predict an increase in the job finding rate in response to an increase in the cross-sectional dispersion of firms’ productivity levels. To explain observed responses in labour market transition rates, I develop a search and matching model in which heterogeneous firms face a decreasing returns to scale technology, firms can hire multiple workers, and job flows (job creation and job destruction) do not necessarily coincide with worker flows (hires and separations). Costly job creation (in addition to the usual hiring cost) is key to obtaining a decrease in the job-finding rate after an increase in uncertainty. Standard numerical solution techniques cannot be used to obtain an accurate solution efficiently and I propose an alternative algorithm to overcome this problem.

Work in Progress

Solving Heterogeneous Agents Models using Past Error Terms of the Law of Motion

I propose to include past error terms of the aggregate law of motion as a state variable, when the infinite-dimensional distribution of heterogeneous agents is approximated. There are several advantages of adding this specific new state variable compared to adding higher moments or other characteristics of the distribution. First, the error term can have high predictive power, because it summarizes the information that was omitted by not including all higher order moments. Second, the error term is not predetermined at the beginning of the period, unlike moments of the distribution. When simulating the economy, it is hence possible to determine the realized error term in each period such that market clearing holds where necessary. It can also be chosen to reduce the difference between actual and predicted future moments of the distribution.

MRes Research Paper

Efficiency of On-the-Job Search in a Search and Matching Model with Endogenous Job Destruction

I analyse the inefficiencies created in a search and matching model that allows for on-the-job search. First, the Hosios rule for the efficient level of the worker's bargaining power is adapted in a simple model. As the average gain of a new match is lower when some job seekers already have a job, the efficient level of labour market tightness should be lower and the worker's bargaining power higher than in a model devoid of on-the-job search. Second, the decision of when to perform on-the-job search is endogenised. It is shown that there is too much on-the-job search taking place because workers do not fully incorporate their current firms' loss when they quit. When partial wage commitment is introduced, the bargaining set becomes non-convex. Using a suitable bargaining process, I prove that wage commitment improves the efficiency of the on-the-job search decision and that the efficient level can be obtained.