Business Cycles in the Equilibrium Model of Labor Market Search and Self-Insurance

The standard Mortensen-Pissarides model of search and matching is extended by introducing capital, risk-averse workers, labor-leisure choice and lack of complete markets to insure away unemployment shocks. The business cycle properties of the model with aggregate productivity shocks are explored, with an emphasis on labor market dynamics. In particular, I ask whether the model can replicate the large volatility of unemployment and vacancies observed in the U.S. economy. Shimer (2005) finds that the standard MortensenPissarides model with productivity shocks of a plausible magnitude does not have a strong amplification mechanism and thus cannot generate the observed cyclical properties of unemployment and vacancies. I find that the answer is yes; the model can generate the observed large volatility of unemployment and vacancies, with a standard calibration. Two channels make the cyclical properties of the model different from Shimer’s (2005) model, namely, the role of savings in mitigating the negative effect of the unemployment shock on current consumption and the additional utility for the unemployed from leisure. I show that both are crucial in the strong amplification mechanism of the baseline model. I also compare the business cycle properties of the model with those of the standard real business cycle model. The model endogenously produces both extensive and intensive margins of labor supply adjustments and thus is able to replicate some business cycle properties of the U.S. economy which the standard model cannot. JEL Classification: D52, E24, E32, J64