The Unemployment Volatility Puzzle: Is Wage Stickiness the Answer?

I study the cyclical behavior of an equilibrium search model with endogenous job creation and destruction and extract from it a wage equation that can be compared with the econometric evidence. Job creation in the model is influenced by wages in new matches. I summarize microeconometric evidence on wages in new matches and show that the key model elasticities are consistent with the evidence. Therefore sticky wages is not the answer to the unemployment volatility puzzle. I discuss some alternative mechanisms that can increase volatility, in particular extensions of the model and alternative driving mechanisms. Jobs in the search and matching model command monopoly rents that are shared between the firm and the worker by a wage contract. The most common wage contract found in the literature is derived from Nash, and yields a wage rate that is a linear combination of the productivity of the match and the worker’s returns from search and nonmarket activities. Pissarides (1985) and Mortensen and Pissarides (1994) have shown that because nonmarket returns are less cyclical than labor productivity, employment in the model exhibits more cyclicality than in a competitive market-clearing model. The question that I address in this paper is the role of wages in the cyclical volatilities implied by this model. Shimer (2005a), in an influential paper, has shown that ∗The Walras-Bowley lecture, North American Summer Meetings of the Econometric Society, Duke University, June 2007. I am grateful to Antonio Antunes, Per Krusell, Rachel Ngai, Michael Reiter, Christian Haefke, Gary Solon for comments and to Pedro Gomes for his research assistance. Partial funding for this study was provided by the Centre for Economic Performance, a designated research centre of the ESRC.