Can Market - Clearing Models Explain U . S . Labor Market Fluctuations ?

(1992) and Kydland (1995) for a survey of this literature. 2 Merz (1995) introduces such time delays in the form of costly search in the labor market while Christiano and Todd (1996) considers a time-to-plan investment process. M odern business cycle theories are evaluated on the basis of their ability to explain key empirical features of the postwar U.S. business cycle. The failure of nonmarket-clearing macro models to account for the rise of unemployment and inflation in the early 1970s led to the rise of New Classical explanations of the business cycle. In particular, the real business cycle (RBC) approach has received much attention in economics because it provides microeco-nomic foundations for macroeconomic behavior and emphasizes the importance of a quantitative evaluation of the theory' s predictions. RBC theory shows how fluctuations in macroeconomic aggregates (recessions and booms) can result from the optimal response of businesses and households to real economic disturbances to technology. These theories are based upon the market-clearing assumption that prices rapidly adjust to demand and supply conditions. Kydland and Prescott (1982) and Long and Plosser (1983) demonstrated that such an approach could explain important facts regarding U.S. business cycles. Using a standard model of economic growth with empirically plausible shocks to aggregate productivity, or technology shocks, their artificial economies generated business cycles remarkably similar to the actual economy. While successful at replicating some key business cycle features, one of the primary weaknesses of standard RBC models is their inability to account for some important aspects of U.S. labor market fluctuations. For example, the standard framework is unable to generate sufficient volatility of hours worked, relative to output and average labor productivity. It vastly overstates the contemporaneous correlation between hours and productivity, and it cannot account for the feature that labor productivity tends to lead hours worked over the business cycle. As a result, researchers in the past decade have focused on modifying the RBC framework to address these shortcomings. 1 One example pursued by Hansen (1985) is to treat labor supply as an indivisible decision (a decision to work or not to work), and hence, introduce equilibrium unemployment. Such an approach alters the individual trade-off between work and leisure over time, which makes labor supply more responsive to changes in the real-wage rate. Another direction is to incorporate additional shocks to the economy, such as changes in government spending (Christiano and Eichenbaum, 1992) or shocks to …