Economic Review 1998 Q3, Federal Reserve Bank of Cleveland

The search theory approach to understanding unemployment flourished during the 1980s and 1990s. It has provided economists with a rich set of models for analyzing unemployment and labor market issues more generally. Unfortunately, while economists have found modern search theory to be an invaluable tool, the insights provided by this approach remain largely unfamiliar to noneconomists. This review is an attempt to reach out to those readers who are interested in acquiring a modern perspective by providing an introduction to the search theory of unemployment. " New economy " proponents claim that favorable supply-side shocks have permanently lowered the nonaccelerating inflation rate of unemployment (NAIRU). If true, this would explain why inflation has not risen over the past couple of years, despite unemployment rates that are well below most NAIRU estimates. What does economic theory have to say about such claims? This article shows that a simple search model of unemployment predicts no long-term change in the NAIRU, although favorable supply shocks may lower the NAIRU over the short term. The key to this result is that workers change their reservation wage (the lowest wage that they will accept) in response to favorable developments in the distribution of wages. The article then considers some extensions that may allow supply shocks to lower the NAIRU permanently. The rates of employment and unemployment are measures of labor market activity that have long been used as indicators of economic performance and welfare. Comparisons of these measures across different regions are typically based on the idea that low levels of employment and high levels of unemployment are associated with low levels of economic performance and general well-being. But in the absence of information concerning the economic circumstances that determine individual labor market choices, such comparisons are not justified. In this article, the authors develop a simple model of labor market activity designed to illustrate the tenuous link that exists between labor market choices and economic well-being.