In a fully competitive labor market, without uncertainty and frictions, employers would be indifferent about whether an employee leaves her job, since they can replace her immediately and at no cost, and at the same competitive wage, with another employee. Accordingly, an employee would be indifferent about losing her job, since she can readily find another one at the same competitive real wage. Moreover, in such a market “involuntary” unemployment cannot exist, because the excess supply of workers would cause an immediate decline in real wages, which would lead to the elimination of unemployment.

In almost all economies there is a positive and non-trivial unemployment rate even in boom periods. There are many unemployed people seeking jobs similar to those held by workers with similar characteristics, at wages equivalent to those generally prevailing in the labor market. At the same time, there are many firms with vacancies, seeking to fill them with employees, possessing characteristics similar to those of the unemployed, and at prevailing real wages. How can then one explain the existence and the fluctuations of both unemployment and vacancies?

The explanation of unemployment is one of the central tasks of macroeconomics. There are two types of questions that are being asked. First, what determines the equilibrium rate of unemployment in an economy, what are its implications, and to what extent the equilibrium unemployment rate reflects labor market distortions. The second key question concerns the cyclical fluctuations of unemployment during the economic cycle.

Cyclical fluctuations in unemployment can be explained by and large by new keynesian models with nominal wage and price contracts, as the ones we have put forward in the previous two chapters. In this chapter we shall delve deeper into the micro foundations of models of the determinants of the equilibrium unemployment rate when there are real labor market frictions. We shall focus on one of the most important models of this latter category, the Mortensen-Pissarides model.

In this model, employers are investing in order to create job vacancies and the process of filling a vacancy involves matching of a firm, which has created a vacancy with an unemployed job seeker.

At each instant, there are two flows into and out of unemployment. Some workers lose their jobs and move from jobs into unemployment, and some of the unemployed find jobs, through the matching process, with firms which have created vacancies.

In the simpler versions of the model the probability of job terminations is exogenous. This parameter describes the structural or cyclical shocks affecting the economy, and leading to the destruction of jobs.

The probability of filling a vacancy, as well as the probability of an unemployed job seeker to find a job, are endogenous variables in this model, and depend on the degree of labor market tightness, which is defined by the ratio of vacancies to the unemployed. The higher the tightness of the labor market, the greater the probability of an unemployed job seeker to find a job, and the lower the probability of a firm to fill a vacancy.

In the steady state, the flows to and from unemployment are equalized, and the equilibrium unemployment rate depends positively on the exogenous probability of job terminations, and negatively on the endogenous probability of an unemployed job seeker to find a job. The equilibrium unemployment rate therefore depends negatively on labor market tightness, and is, of course, determined endogenously. The negative relationship between the unemployment rate and the vacancy rate which is implied by this dependence is known as the Beveridge curve.

Firms and the unemployed make their decisions rationally, maximizing the expected present value of their profits and income.

Firms create new vacancies as long as the expected profits from the investment required to create a vacancy are positive. The condition for a vacancy to be filled, and for a new job to be created is that the real wage should be equal to labor productivity minus the cost of creating and maintaining a vacancy. By filling a vacancy, a firm must in equilibrium cover both the wage costs and the costs of its investment in the creation of the vacancy.

The job creation condition implies a negative relationship between the wage that the firm is willing to pay and labor market tightness. The higher is labor market tightness, the lower is the probability of filling a vacancy and the greater the total cost of maintaining a vacancy, since vacancies remain unfilled for longer.

On the other hand, an unemployed job seeker will agree to get a job if the expected present value of income of an employed worker is greater than the expected present value of income of an unemployed job seeker. This condition is satisfied in this model, as long as the real wage is higher than unemployment benefits.

Real wages are determined in equilibrium by decentralized bargaining between firms that have vacancies and unemployed job seekers. The equilibrium real wage is the result of this negotiation, and depends positively on the relative bargaining power of the unemployed, the level of unemployment benefits, labor productivity, the cost of maintaining a vacancy and labor market tightness. The equilibrium real wage depends positively on labor market tightness, as this increases the average recruitment cost per unemployed person, thereby increasing the “threat” point of prospective employees versus prospective employers, and weakening the effective bargaining position of prospective employers.

The positive relationship between real wages and labor market tightness, resulting from the negotiation between firms with vacancies and the unemployed, and the negative relationship between real wages and and labor market tightness implied by the job creation condition for firms, jointly determine the equilibrium real wage and equilibrium labor market tightness. For given equilibrium labor market tightness, the equilibrium unemployment rate is then determined through the Beveridge curve, which implies a negative relationship between the unemployment and vacancy rates.

In the equilibrium of this model, the unemployed are worse off than the employed. Consequently unemployment is an undesirable and involuntary condition, and not the result of choice by the unemployed, as in competitive models of the labor market without frictions.

If unemployment benefits are proportional to the real wage, labor productivity does not affect the equilibrium unemployment rate in this model.

However, the higher the percentage of real wages paid out as unemployment benefits, the higher the equilibrium real wage and the higher the equilibrium unemployment rate. the percentage of actual salary paid as unemployment benefit, the higher real wages in the balance and the higher the unemployment rate. The reason is that higher real wages reduce incentives for creating new jobs, thus reducing the number of vacancies, reducing labor market tightness and increasing unemployment.

An increase in real interest rates also has a positive impact on unemployment in this model, because it increases the cost of maintaining a vacancy, resulting in the creation of fewer job vacancies, lower labor market tightness and higher unemployment.

A rise in the exogenous probability of job terminations has a positive impact on unemployment for two reasons. First because it directly increases the flows from existing jobs to unemployment, and, second, because it, indirectly, reduces the flows from unemployment to jobs. The second effect takes place because the expected profit from the creation and filling of a vacancy falls, resulting in fewer vacancies and reduced flows from unemployment to jobs.

In this model, equilibrium unemployment depends both on cyclical and structural factors. Moreover, unlike the new classical model of real economic cycles, but like some versions of the “New Keynesian” model, unemployment is “involuntary” in the sense that the unemployed would always prefer to be in jobs at prevailing real wages.

The adjustment path predicted by the model is stable, as, following shocks to the determinants of equilibrium unemployment, the unemployment rate follows a unique and stable adjustment path towards the new equilibrium.

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