Shopping Externalities and Self-Fulfilling Unemployment Fluctuations∗

We propose a novel theory of self-fulfilling fluctuations in the labor market. A firm employing an additional worker generates positive externalities on other firms, because employed workers have more income to spend and have less time to shop for low prices than unemployed workers. We quantify these shopping externalities and show that they are sufficiently strong to create strategic complementarities in the employment decisions of different firms and to generate multiple rational expectations equilibria. Equilibria differ with respect to the agents’ (rational) expectations about future unemployment. We show that negative shocks to agents’ expectations lead to fluctuations in vacancies, unemployment, labor productivity and the stock market that closely resemble those observed in the US during the Great Recession. ∗Kaplan: Department of Economics, Princeton University, Fisher Hall, Princeton, NJ 08544 (email: [email protected]); Menzio: Department of Economics, University of Pennsylvania, 3718 Locust Walk, Philadelphia, PA 19013 (email: [email protected]). We thank the Kielts-Nielsen Data Center at the University of Chicago Booth School of Business for providing access to the Kielts-Nielsen Consumer Panel Dataset. We are grateful to Mark Aguiar, Jim Albrecht, Costas Azariades, Roger Farmer, Veronica Guerrieri, Erik Hurst, Bob Hall, Venky Venkateswaran, Susan Vroman, Steve Williamson and Randy Wright. We are also grateful to seminar participants at ASU, Bocconi, Bonn, Chicago Booth, EIEF, Georgetown, LSE, Princeton, Rochester, Saint Louis FRB, UCLA and from participants at the Search and Matching Workshop (Philadelphia 2012), Society for Economic Dynamics Meeting (Cyprus 2012) and NBER Summer Institute (Cambridge 2012).