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Lecture2

The document discusses the Search and Matching Model in macroeconomics, focusing on the Diamond-Mortensen-Pissarides (DMP) framework to analyze unemployment dynamics and labor market policies. It highlights key concepts such as job finding rates, vacancy creation, and wage determination through a bargaining process, while also addressing the implications of labor market frictions. The lecture aims to provide insights into the relationship between unemployment and job vacancies, supported by empirical data and theoretical models.

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Runsheng Wang
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
0% found this document useful (0 votes)
2 views

Lecture2

The document discusses the Search and Matching Model in macroeconomics, focusing on the Diamond-Mortensen-Pissarides (DMP) framework to analyze unemployment dynamics and labor market policies. It highlights key concepts such as job finding rates, vacancy creation, and wage determination through a bargaining process, while also addressing the implications of labor market frictions. The lecture aims to provide insights into the relationship between unemployment and job vacancies, supported by empirical data and theoretical models.

Uploaded by

Runsheng Wang
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Econ 2010d: Heterogeneity in Macroeconomics

Lecture 2: The Search and Matching Model

Adrien Bilal
Spring 2024
Harvard
Introduction
Recap: Unemployment Facts

• St.dev. of unemployment rate ≈ 1.5 p.p. over the cycle

• Job finding rate accounts for ≈ 60 − 90% of that variation

• Vacancy creation strongly procyclical (Beveridge curve, elasticity - 1)

• Job finding rate positively related to V/U ratio (elasticity 0.4)

I Build model that speaks to those facts


I The Diamond-Mortensen-Pissarides (DMP) model
I Sometimes just called the “Search and Matching model”
I So that we can evaluate labor market policies

1 / 31
Some History
From Keynes to the DMP Model
• Keynes hypothesized that low aggregate (goods) demand leads to low output
I Low labor demand & high unemployment

• Two difficulties
I In the NK model, only (mostly) intensive margin and need very high Frisch
F Can use employment lotteries ⇒ Do we observe them in practice?
I No simultaneous flows in and out of unemployment

• Led to development of the DMP model


I Structures the movements in and out of unemployment & wage-setting
I Initially abstract from wage rigidity ⇒ will help with empirical performance!
I Diamond, Mortensen, Pissarides, Hall, Shimer

I
2 / 31
Setup
Preferences
• Discrete time t = 0, 1, ..., ∞

• Unit measure of ex-ante identical risk-neutral workers, discount factor β < 1


I Maximize present value of income stream It
"∞ #
X t
E0 β It
t=0

I Equivalently can be hand-to-mouth


I Risk-neutrality shuts down Euler equation at the heart of RBC/NK models
I Instead focus on cyclical patterns of labor market

• Risk-neutrality implies βR = 1 in equilibrium: β also discount factor of firms

• Employed workers receive an equilibrium wage wt (more on this later)

• Unemployed workers receive unemployment benefits/utility from leisure b

3 / 31
Technology: Production

• A firm uses one worker to produce zt units of output

• zt ∈ {z 1 , ..., z Z } follows a Markov chain with transition matrix T


I Can think about it as proxying aggregate demand
I Though in this simple model analogy is imperfect

• Alternatively can have CRS firms that employ many workers

4 / 31
Technology: Search and Matching
• A vacant firm (i.e. without a worker) incurs a vacancy cost c every period

• A vacant firm posts one vacancy per period (again immaterial under CRS)
I Denote vt the equilibrium measure of vacancies
I A competitive fringe of firms stands ready to enter and post vacancies

• Denote ut the measure of unemployed workers = unemployment rate

• Vacancies and unemployed workers meet according to a matching function:

Mt = M(ut , vt )
I Mt matches formed every period
I Today use Cobb-Douglas

M(u, v ) = mu α v 1−α

I All qualitative results extend to any CRS matching function

5 / 31
Matching in the Labor Market (1/2)
• Useful to define labor market tightness
vt
θt =
ut
• Probability of unemployed finding a job in current period
Mt
ft = −→ f (θ) = mθ1−α
ut
I We assumed random matching
I Matches distributed randomly to unemployed workers

• Probability that a vacant firm finds a worker


Mt
qt = −→ q(θ) = mθ−α = f (θ)/θ
vt
• Suppose m small enough that ft , qt ∈ [0, 1]
• Probability that a job terminates s is exogenous
I Can interpret as probability that zt falls below b
I Was less important than job finding rate for aggregate fluctuations
I Will endogenize in problem set 6 / 31
Matching in the Labor Market (2/2)

• Matching function summarizes the complex functioning of the labor market


I Imperfect information
I Time to locate job offers and apply
I Screening
I Processing times

• Can write micro-foundations of matching function


I Can sometimes imply different functional forms than CB

• Recall Lecture 1: log f was close to linear in v /u = θ

7 / 31
Lecture 1: Vacancies and the Job Finding Rate

1
.75
.5
log UE (de-meaned)
.25
0
-.25
-.5
-.75
-1

-1 -.75 -.5 -.25 0 .25 .5 .75 1

log v/u (de-meaned)


2001Q1-2008Q4 2009Q1-2020Q1
log UE = 0.38 * log v/u

• Recall Lecture 1: log f was close to linear in v /u = θ


I Regression log ft = (1 − α) log θt + log mt implies 1 − α = 0.4 and so α = 0.6
I If can interpret relationship as causal!
I Any issues with that?

• For aggregate data: CB good approximation

8 / 31
Value Functions
Value Functions

• Value of being unemployed


h i
Ut = b + βEt ft Et+1 + (1 − ft )Ut+1

• Value of being employed


h i
Et = wt + βEt sUt+1 + (1 − s)Et+1

• Value of vacant job/firm


h i
Vt = −c + βEt qt Jt+1 + (1 − qt )Vt+1

• Value of filled job/firm


h i
Jt = zt − wt + βEt sVt+1 + (1 − s)Jt+1

9 / 31
Surpluses
• The worker surplus is E − U and satisfies
 
Et − Ut = wt − b + βft Et [Et+1 − Ut+1 ] + β(1 − s)Et [Et+1 − Ut+1 ]
| {z }
foregone search value

• The firm surplus is J − V


I Impose free entry: Vt = 0
I So the firm surplus is just J and satisfies:

Jt = zt − wt + β(1 − s)Et [Jt+1 ]

• The match surplus is S = E + J − (U + V ) = E + J − U and satisfies


 
St = zt − b + βft Et [Et+1 − Ut+1 ] + β(1 − s)Et [St+1 ]

I Joint surplus independent from wages: Transferable utility!


I Pervasive property of search models with linear payoffs
I Useful for wage determination
10 / 31
Free Entry

• Free entry of firms implies Vt = 0 and so:

c = βqt Et [Jt+1 ]

I Vacancy creation adjusts until the cost equals expected future benefits
I Equilibrating force through qt = m (vt /ut )−α

11 / 31
Wage Determination
Non Competitive Labor Market

• The labor market is not competitive


I Competitive market: reallocation between buyers/sellers is instantaneous
F Arbitrages away any price differences
I Here reallocation takes time: labor market frictions (matching function)

• Cannot use the usual notion of labor market clearing to determine wages

• Instead, workers and firms face a bilateral monopoly when they meet
I If firm walks away, worker loses wage this period and must search again
I If worker walks away, firm loses profits this period and must search again

• Need to specify a resolution of the bilateral monopoly


I Several approaches, start with most common one today

12 / 31
Generalized Nash Bargaining
• Firms have no commitment power: cannot announce wage and stick to it

• Instead wage is determined after meeting occurs

• Renegotiated every period t

• Wage such that surplus is split between worker and firm with shares γ, 1 − γ:

wt = argmax(Et (w ) − Ut )γ Jt (w )1−γ

I γ called bargaining power of worker


I Microfoundation through alternative offer game à la Rubinstein (1980)

• Equilibrium wage satisfies the surplus-sharing equation

Et (wt ) − Ut = γSt , Jt (wt ) = (1 − γ)St

I Useful that joint surplus independent from wage

13 / 31
Equilibrium Wage
• Surplus-sharing rule implies:
 
wt = (1 − γ) b + βft γEt [St+1 ] + γzt

Weighted average between


I Worker’s flow outside option b plus foregone option value of search
I Firm’s flow output zt

• Can use free-entry to express βft (1 − γ)Et [St+1 ] = θt c:

wt = (1 − γ)b + γ(zt + θt c)

Equivalently weighted average between


I Worker’s flow outside option b
I Firm’s flow output zt plus cost-saving from not advertising jobs

• Wages are flexible because renegotiated every period


I Search frictions and price rigidities are distinct departures from RBC
14 / 31
Equilibrium: Tightness and Unemployment

• Given surplus sharing, re-write Bellman equation for joint surplus

St = zt − b + β(1 − s − γft )Et [St+1 ]

• Free-entry determines tightness θt :

c = βqt (1 − γ)Et [St+1 ]

• Unemployment follows the stock-flow equation

ut+1 − ut = s(1 − ut ) − ft ut

15 / 31
Comparative Statics
Steady-State

• Impose zt ≡ z and ut ≡ u at all time periods


I Surplus equation: S = z − b + β(1 − s − γf )S
I Free-entry: c = βq(1 − γ)S

• Combine to summarize steady-state by


I Job creation condition
r + s + γf (θ) z −b
= , r ≡ β −1 − 1
(1 − γ)q(θ) c
I Stock-flow identity/Beveridge curve
s
u=
s + f (θ)

16 / 31
Steady-State: First Pass (1)
• To gain intuition, log-linearize w.r.t. z:

1−γ dz
dθ =
γ + α(r + s)/f c

I Log-linearization as in RBC/NK with Marty

• Can also log-linearize w.r.t. r , s  f (θ):

1−γ z −b
θ ≈
γ c
s 1 s α
log u ≈ log − (1 − α) log θ ⇐⇒ log v ≈ log − log u
m 1−α m 1−α

I Here did not log-linearize w.r.t. aggregate shocks


I Instead log-linearized w.r.t. parameters r , s, m
F Motivated by the data: r ∼ 0.004, s ∼ 0.01, f ∼ 0.2 monthly
I Sometimes easier and/or leads to cleaner expressions

17 / 31
Steady-State: First Pass (2)

• We use the second log-linearization:

1−γ z −b 1 s α
θ≈ , log v ≈ log − log u
γ c 1−α m 1−α

• More vacancies relative to unemployed workers if


I Firm profit share 1 − γ is large
I Productivity z relative to unemployment value b is large
I Vacancy cost c is low

18 / 31
The Beveridge Curve: Data & DMP

9
8.5
log vacancies
8
7.5

1 1.5 2 2.5 3

log unemployment rate


2001Q1-2008Q4 2009Q1-2020Q1

1 s α
log v ≈ log − log u
1−α m 1−α
• With α ≈ 0.6 Beveridge curve has slope ≈ −1 as in data
I Is this surprising? Not so much
I Beveridge curve & matching fct regressions fit combinations of (log v , log u)
• Shift of Beveridge curve during Great Recession: m ↓
19 / 31
Steady-State: Comparative Statics w.r.t. Productivity
• Log-linearize w.r.t. z:
du r + s + γf z dz
= − (1 − u) (1 − α)
u α(r + s) + γf z −b z
| {z }
≈1 when r ,sf

• Log-linearize w.r.t r , s  f :
du z dz
u = cste × (z − b)−(1−α) =⇒ = −(1 − α)
u z −b z
• Steady-state comparative statics also informative about effect of shocks
I Recall that transitions in stock-flow model are virtually instantaneous

• In data
du
I
u
∼ 20 − 30%
Y dz
I If use labor productivity z = N
, z
∼ 2%

• To match data, need


z b
∼ 20 ⇐⇒ ∼ 95%
z −b z
20 / 31
The Unemployment Volatility Puzzle

• Shimer (2005): for plausible values of b, DMP model fails quantitatively


du
I From unemployment insurance b/z ∼ 0.4 ⇒ u
∼ 1%

21 / 31
A First Resolution?

• Hagedorn Manovskii (2008): high b reconciles DMP model and data


1
I Relies heavily on functional form and divergence of 1−b/z
close to 1

• Chodorow-Reich Karabarbounis (2016): careful measurement → b/z ∼ 0.05


I Incorporate unemployment insurance take-up, expiration, etc.
I Look at effective rates rather than statutory rates

22 / 31
Unpacking the Unemployment Volatility Puzzle

• Unemployment varies too little because tightness reacts too little

1
θ ≈ × (1 − γ)(z − b)
γc

I And so vacancies also react too little relative to data

• Key to vacancy creation are


I Free entry: ≈
I Firm’s profits: (1 − γ)(z − b)

• Explore role of both

23 / 31
Job Creation
Free Entry and Job creation Costs (1/2)

• Now suppose fixed measure M of firms enter each period

• Instead of linear vacancy cost cv , face strictly convex cost C (v ) = c0 v 1+ν


1+ν
I When C (v ) is linear (ν = 0) get back previous model
I With linear costs M vs. V irrelevant

• Previous equations hold after replacing c with c(v ) = C 0 (v )


I After adjusting for M in tightness

• Free entry now

c0 vtν = βqt (1 − γ)Et St+1

24 / 31
Free Entry and Job creation Costs (2/2)

• Key results becomes, to leading order when r , s  f (θ):

1−γ z −b du 1−α z dz
θ1+αν ≈ cste , ≈−
γ c0 u 1 + αν z − b z

I Tightness/unemployment even less responsive


I In expansions, hiring cost rises, dampening job creation
I In downturns, hiring cost declines, stimulating job creation

• Departures from linear cost do not resolve the unemployment volatility puzzle
I Convex costs make tightness even less responsive to shocks
I Needed tightness more responsive to shocks!

25 / 31
Wage Rigidity
Wage Rigidity in the DMP Model

• Return to linear cost model

• Recall so far, search frictions 6= wage rigidity


I Search ⇒ bilateral monopoly, resolved with bargaining
I Wage flexibly renegotiated every period
I Implications rely heavily on generalized Nash bargaining

• Introducing wage rigidity amounts to dropping/changing bargaining protocol


I Hall (2005)

26 / 31
Another Wage Setting Mechanism
• Any agreed upon wage must make
I Workers better off than being unemployed
I Firms better off than being vacant

• Any wage w such that

Et (w ) ≥ Ut
Jt (w ) ≥ 0

satisfies workers’ and firms’ participation constraints


I Under any such wage, matches are formed and no surplus is left on the table

• Any constant wage w is participation compatible if

b ≤ w ≤ inf (1 − β(1 − s))J t , where J t = zt + β(1 − s)Et [J t+1 ]


t

I Follows from simple algebraic manipulations of value functions


I If zt is constant get b ≤ w ≤ z
27 / 31
Hall’s Resolution of the Unemployment Volatility Puzzle

1. Choose a “long-run” wage w


I Hall (2005) uses the steady-state symmetric Nash bargaining wage (γ = 0.5)
I Idea: long-run level of wages determined by negotiations
I Obtains w /z = 0.96 in steady-state

2. Impose that wages fixed in the short-run: wt ≡ w


I Even in response to productivity shocks dzt
I Different from generalized Nash bargaining each period
I Wages are rigid

du
3. Obtains u ∼ 0.2 as in the data

28 / 31
Why Do Rigid Wages Work?
• No “surplus sharing” out of steady-state: Jt 6= γSt

• Can solve for Jt given fixed wage w

• Job creation now c = βqt Et Jt+1

• Job creation + Beveridge curve now imply when r , s  f


!
du 1 − α z dz du z dz
≈− v.s. ≈ −(1 − α)
u α z −w z u z −b z

• Two main differences


I 1/α: because worker’s wage does not depend on outside option anymore
F Bargained wage ⇒ ↑ in booms ⇒ profits ↓ ⇒ dampens vacancy creation
z z
I
z−w
instead of z−b
F Most of the action
F By fixing wage, relevant profits are z − w instead of (1 − γ)(z − b)
F Highlights that failure of bargaining model highly dependent on functional form

• Hall Milgrom (2008) microfound “rigid” wages with different bargaining


29 / 31
Taking Stock

• DMP model (with bargaining)


I Qualitatively speaks to facts about unemployment
I Quantitatively struggles to match unemployment volatility w/ prod. shocks

• Saw two resolutions today


I b/z ≈ 1: hard to justify
I Rigid wages: more promising
F Relevant if applies to wage of new hires, not incumbent workers
F Non-trivial to micro-found (Hall Milgrom 2008)
F Non-trivial to reconcile with wage cyclicality in data

• Next lecture: will study efficiency properties of DMP model

30 / 31
Bonus
Other resolutions

• Different bargaining (Hall Milgrom 2008)


I Observe that standard alternating offer solution is not a PBE
I Going back to unemployment is not credible while bargaining
I Alternative bargaining that reduces wage dependence on outside options
F “Microfounded” wage rigidity

• On-the-job search (Fujita Ramey 2012)


I Anchors expected hiring cost to existing wages ≈ wage rigidity

• Marginal vs. average workers (Elsby Michaels 2013)


I Firms have DRS, choose size to equate marginal product of labor to b
I As if b/z ≈ 1 endogenously

• Stock market valuations shocks rather than productivity (Kehoe et al. 2021)
I z should reflect firm’s valuation of jobs, stock market fluctuates much more

31 / 31

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