Working Paper 07 - 25 December 2007 On - the - Job

Working papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded offi cial Federal Reserve Bank of Cleveland publications. The views stated herein are those of the authors and are not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. This paper studies ampli cation of productivity shocks in labor markets through on-the-job-search. There is incomplete information about the quality of the employee-fi rm match which provides persistence in employment relationships and the rationale for on-the-job search. Amplifi cation arises because productivity changes not only affect fi rms' probability of contacting unemployed workers but also of contacting already employed workers. Since higher productivity raises the value of all matches, even low quality matches become productive enough to survive in expansions. Therefore the measure of workers in low quality matches is greater when productivity is high, implying a higher probability of switching to another match. In other words, fi rms are more likely to meet employed workers in expansions and those they meet are more likely to accept a fi rm's job offer because they are more likely to be employed in a low quality match. This introduces strongly procyclical labor market reallocation through procyclical job-to-job transitions. Simulations with a productivity process that is consistent with average labor productivity in the U.S. show that standard deviations for unemployment , vacancies and market tightness (vacancy-unemployment ratio) match the U.S. data. The model also reconciles the presence of endogenous separation with the negative correlation of unemployment and vacancies over business cycle frequencies (i.e. it is consistent with the Beveridge curve). Murat Tasci is an economist at the Federal Reserve Bank of Cleveland. He can be reached at [email protected].