Uncertainty, Productivity and Unemployment in the Great Recession∗

The 2007-2009 recession has witnessed two phenomena that standard search models of the labor market have difficulty reconciling: a large and persistent increase in unemployment and a sharp rise, above pre-recession levels, in labor productivity following a small initial drop. In addition, these observations were accompanied by a significant increase in the dispersion of firm growth rates. In this paper, I introduce idiosyncratic volatility shocks in search-and-matching models to study if they can account for the patterns observed in US labor markets during the recession. To that end, I develop a tractable dynamic search model of heterogeneous firms with decreasing returns to labor. The model features directed search and allows for endogenous separations, entry and exit of firms, and job-to-job transitions. I show, first, that the model is consistent with a number of observations at the establishment and cross-sectional levels. Second, I find that the introduction of establishment dynamics provides an additional propagation mechanism to the model with productivity shocks only, but cannot by itself account for the total fluctuations in unemployment. Volatility shocks, on the other hand, quite significantly enhance the ability of the model to account for the magnitude of changes observed in output and labor market flows, as well as the coexistence of high unemployment and high productivity. However, the uncertainty induced by the rise in volatility is not sufficient to explain the large persistence in unemployment observed after 2010.