Modelling Capital in Matching Models: Implications for Unemployment Fluctuations

Analysis of the the standard labor-market matching model usually focuses on labor productivity as an important source business of cycles. A shortcoming of this model is that it cannot account for observed labor market fluctuations with aggregate labor productivity as the only shock in the economy. Yet analysis of this framework disregards another potentially important source of business cycle fluctuations, namely investmentspecific technical change (ISTC). In order to study the implications of ISTC for the matching model, one must first introduce capital accumulation into this model. We propose a simple extension of the search model to allow for vintage capital. We take as the defining feature of vintage capital the fact that the capital content of a machine vintage cannot be adjusted after the vintage has been introduced, i.e., after investment has taken place. For a calibrated version of our vintage capital model we find that unemployment and real wages are more volatile than in the standard search model. Whether or not ISTC significantly amplifies unemployment fluctuations depends crucially on the persistence of ISTC: the less persistent it is, the higher is unemployment volatility. ∗Andreas Hornstein is at the Federal Reserve Bank of Richmond. Per Krusell is at Princeton University, the Institute for International Economic Studies, CAERP, NBER, and CEPR. Giovanni L. Violante is at New York University and CEPR. The views expressed in this article are those of the authors and not necessarily those of the Federal Reserve Bank of Richmond or the Federal Reserve System.