NBER WORKING PAPER SERIES UNEMPLOYMENT CRISES. Nicolas Petrosky-Nadeau Lu Zhang. Working Paper

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1 NBER WORKING PAPER SERIES UNEMPLOYMENT CRISES Nicolas Petrosky-Nadeau Lu Zhang Working Paper NATIONAL BUREAU OF ECONOMIC RESEARCH 15 Massachusetts Avenue Cambridge, MA 2138 July 213 We are grateful to Hang Bai, Andrew Chen, Daniele Coen-Pirani, Steven Davis, Paul Evans, Wouter Den Haan, Lars-Alexander Kuehn, Dale Mortensen, Paulina Restrepo-Echavarria, Etienne Wasmer, Randall Wright, and other seminar participants at The Ohio State University and the 213 North American Summer Meeting of the Econometric Society for helpful comments. Nicolas Petrosky-Nadeau thanks Stanford Institute for Economic Policy Research at Stanford University for its hospitality. All remaining errors are our own. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. 213 by Nicolas Petrosky-Nadeau and Lu Zhang. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including notice, is given to the source.

2 Unemployment Crises Nicolas Petrosky-Nadeau and Lu Zhang NBER Working Paper No July 213 JEL No. E24,E32,G1,G12 ABSTRACT A search and matching model, when calibrated to the mean and volatility of unemployment in the postwar sample, can potentially explain the large unemployment dynamics in the Great Depression. The limited response of wages to labor market conditions from credible bargaining and the congestion externality from matching frictions cause the unemployment rate to rise sharply in recessions but decline gradually in booms. The frequency, severity, and persistence of unemployment crises in the model are quantitatively consistent with U.S. historical time series. Nicolas Petrosky-Nadeau Carnegie Mellon University Tepper School of Business 5 Forbes Avenue Pittsburgh, PA 1526 npn@andrew.cmu.edu Lu Zhang Fisher College of Business The Ohio State University 21 Neil Avenue Columbus, OH 4321 and NBER zhanglu@fisher.osu.edu

3 Figure 1 : Monthly U.S. Unemployment Rates, April 1929 to December Introduction Figure 1 plots the monthly U.S. unemployment rates from April 1929 to December 212 (see Section 2 for sample construction). The mean unemployment rate is 6.97%, and the median rate is 5.7%. The most striking feature of the figure is the extraordinarily high levels of unemployment in the 193s, known as the Great Depression. From January 1931 to December 1939, the average unemployment rate is 17.57%, and the highest unemployment rate reaches 25.59% in May In contrast, such large unemployment dynamics are absent in the postwar sample. We fit a threestate Markov chain on the unemployment rate series via maximum likelihood. Identifying months in which the unemployment rate is above 2% as a crisis state, we estimate the unconditional probability of an unemployment crisis to be 2.76% and its persistence (the probability of a crisis next period conditional on a crisis in the current period) to be 88.89%. We ask whether a Diamond-Mortensen-Pissarides model of equilibrium unemployment, when 1

4 calibrated to the mean and volatility of unemployment in the postwar sample, can explain the large unemployment dynamics in the Great Depression. Perhaps surprisingly, the answer is affirmative. Unemployed workers search for vacancies posted by a representative firm. A matching function takes vacancies and unemployed workers as inputs to produce the number of new hires in the labor market. Because of matching frictions, the vacancy filling rate decreases with the tightness of the labor market measured as the ratio of the number of vacancies over the number of unemployed workers. Deviating from the standard wage determination via a generalized Nash bargaining game, we follow Hall and Milgrom (28) to derive the equilibrium wage as the outcome of a credible bargaining game. In this setup, both parties make alternating offers that can be accepted, rejected to make a counteroffer, or rejected to take outside options. Relative to the Nash wage, the credible bargaining wage is more insulated from conditions in the labor market. Our key finding is that the model, calibrated to match the mean of 5.84% and the volatility of 13.48% for the unemployment rate in the postwar sample, can match the persistence and the unconditional probability of the crisis state in the full sample. The persistence of the crisis state is 86.96% in the model, and its unconditional probability is 3.18% (with a cross-simulation standard deviation of 7.72%). The volatility of unemployment in the model s crises samples is.233, which is more than twice as large as.19 in normal periods. Remarkably, the model moment is close to the unemployment volatility of.219 in the long U.S. sample from April 1929 to December 212. The unemployment dynamics in the model are large and extremely nonlinear. In booms unemployment declines only gradually, whereas in recessions unemployment rises drastically. The model s empirical stationary distribution of unemployment is highly skewed with a long right tail. Also, impulse responses are stronger in recessions than in booms. In response to a negative onestandard-deviation shock to log labor productivity, the unemployment rate increases only by.5% if the economy starts at the 95 percentile of the model s stationary distribution of employment and productivity. In contrast, the unemployment rate jumps by 1.6% (more than 2 times larger) if the economy instead starts at the 5 percentile of the bivariate distribution. 2

5 The probability of breakdown in wage bargaining and the delaying cost incurred by the firm during each round of alternating offers (which are two key parameters in the credible bargaining game) are quantitatively important for the crisis dynamics in the model. A higher probability of breakdown, in which both parties take outside options, brings credible bargaining closer to Nash bargaining and makes the equilibrium wage more response to labor market conditions. In recessions, labor productivity falls, but the wage also drops, making profits less sensitive to downturns and providing the firm with incentives to create jobs. As such, crisis dynamics in unemployment are dampened. In contrast, a higher delaying cost makes the equilibrium wage more insulated from labor market conditions. As output falls in recessions, the wage does not fall as much, meaning that profits must drop disproportionately more. As such, crisis dynamics are strengthened. The congestion externality also plays a role in driving our results. The congestion arises because in booms many vacancies compete for a small pool of unemployed workers. An extra vacancy can cause a large drop in the vacancy filling rate, raising the marginal cost of hiring. In contrast, in recessions many unemployed workers compete for a small pool of vacancies. An extra vacancy is quickly filled, and the vacancy filling rate can hardly increase further. As such, the marginal cost of hiring runs into a downward rigidity in recessions. This effect is also buttressed by the fixed matching cost that puts a constant component into the marginal cost of hiring. Consider a large negative shock to labor productivity. Output falls, but profits plummet more because the credible bargaining wage is relatively insulated from aggregate conditions. To make matters worse, the marginal cost of hiring runs into the downward rigidity, failing to decline to counteract the impact of plummeting profits on the firm s incentives of hiring. As a result, unemployment rises drastically, giving rise to crises. Quantitatively, the log productivity levels that are two and three unconditional standard deviations below its unconditional mean would lead to unemployment rates of 13% and 28%, respectively. To reach the crisis threshold of 2% unemployment rate, the log productivity must drop 2.62 unconditional standard deviations below the unconditional mean. Most important, the search and matching model endogenizes unemployment crises similar 3

6 to the Great Depression, even though the exogenous driving force is a first-order autoregressive process with homoscedastic lognormal shocks as in the standard business cycle literature. To evaluate the quantitative importance of credible bargaining in the model, we experiment with the baseline search model with the equilibrium wage determined from the standard Nash bargaining. We find that the model can quantitatively explain the same crisis dynamics in unemployment, but only with either an excessively high flow value of unemployment activities or an extremely high fixed matching cost. Both calibrations do not appear realistic. As such, we conclude that the credible bargaining framework is essential in providing a realistic microfoundation for unemployment crises. The theoretical foundations for the search model of unemployment are provided by Diamond (1982), Mortensen (1982), and Pissarides (1985). Shimer (25) contributes a simple yet profound insight that the unemployment volatility in the baseline search model is too low relative to that in the data. 1 As noted, our model is built on Hall and Milgrom (28), who show that replacing the Nash wage with the credible bargaining wage helps explain the volatility puzzle. Going beyond the volatility puzzle in the labor market, our central contribution is to push the search model of unemployment to explain the crisis dynamics of unemployment in the Great Depression. Kuehn, Petrosky-Nadeau, and Zhang (213) embed the search model of unemployment into an equilibrium asset pricing framework. With recursive preferences, their work focuses on asset prices and related consumption disasters. Our work differs by focusing on labor market dynamics (in particular, unemployment crises as well as their impact on the second moment of the labor market). Most important, we move beyond the Nash bargaining to the Hall and Milgrom (28) credible bargaining to provide a rich microfoundation for unemployment crises. The rest of the paper is organized as follows. Section 2 documents the nonlinear dynamics in the 1 A large subsequent literature has developed to tackle the volatility puzzle. In particular, Hall (25) shows how wage stickiness, which satisfies the condition that no worker-firm pair has any unexploited opportunity for mutual gain, increases labor market volatilities. Mortensen and Nagypál (27) and Pissarides (29) show that the fixed recruiting cost can explain the volatility puzzle. Hagedorn and Manovskii (28) show that a calibration with small profits and a low bargaining power for the workers can produce realistic volatilities. Petrosky-Nadeau and Wasmer (213) show how incorporating financial frictions can generate higher labor market volatilities. 4

7 historical U.S. unemployment rates. Section 3 presents the search and matching model. Section 4 calibrates the model and discusses its accurate solution algorithm. Section 5 quantifies the model s crisis dynamics in unemployment. Finally, Section 6 concludes. 2 Evidence on Unemployment Crises We construct a monthly time series for the U.S. unemployment rate stretching back to April of 1929 by drawing from NBER macrohistory files. We access the data via Federal Reserve Economic Data (FRED) at Federal Reserve Bank of St. Louis. We concatenate four different series of the U.S. unemployment rate: (i) the seasonally adjusted unemployment rate from April 1929 to February 194 (NBER data series m8292a, FRED series ID: M892AUSM156SNBR); (ii) the seasonally adjusted unemployment rate from March 194 to December 1946 (NBER data series m8292b, FRED series ID: M892BUSM156SNBR); (iii) the unemployment rate (not seasonally adjusted) from January 1947 to December 1947 (NBER data series m8292c, FRED series ID: M892CUSM156NNBR); and (iv) the seasonally adjusted civilian unemployment rate from January 1948 to December 212 from Bureau of Labor Statistics at U.S. Department of Labor (FRED series ID: UNRATE). To model the tail behavior in the U.S. unemployment rate series plotted in Figure 1, we follow Chatterjee and Corbae (27) to fit a three-state Markov chain model via maximum likelihood. The aggregate state of the economy, η {g, b, c}, evolves through good (g), bad (b), and crisis (c) states with different employment prospects. Let the transition matrix of the Markov Chain be given by: λ gg λ bg λ cg Λ= λ gb λ bb λ cb, (1) λ gc λ bc λ cc in which, for example, λ gb Prob{η t+1 = g η t = b} is the probability of the economy being in state g next period conditional on the economy being in state b in the current period. As discussed in Chatterjee and Corbae (27), the maximum likelihood estimate of λ kj,which is the (j, k)th element of the aggregate state transition matrix, is the ratio of the number of times 5

8 the economy switches from state j to state k to the number of times the economy is in state j. Let, for example, 1 {ηt =j} denote the indicator function that takes the value of one if the economy in period t is in state j and zero otherwise. The maximum likelihood estimate of λ kj is given by: ˆλ kj = T 1 t=1 1 {η t+1 =k}1 {ηt =j} T 1 t=1 1. (2) {η t =j} In addition, the asymptotic standard error for ˆλ kj is given by: Ste(ˆλ kj )= ˆλ kj (1 ˆλ kj ) T t=1 1. (3) {η t =j} In practice, we identify the good state, g, as months in which the U.S. unemployment rate is below the median unemployment rate of 5.7%. We define the crisis state, c, asmonthsinwhich the U.S. unemployment rate is above or equal to 2%. The bad state, b, is then identified as months in which the unemployment rate is below 2% but above or equal to the median of 5.7%. We choose the crisis cutoff rate of 2% judiciously such that (i) the cutoff rate is relatively high; but (ii) there are still a sufficient number of months in which the economy hits the crisis state so that the transition probability estimates can be (relatively) precise. Table 1 reports the estimated aggregate state transition matrix. The crisis state is persistent in that the probability of the economy remaining in the crisis state conditional on it being in the crisis state is 88.9%. This estimate is also precise, with a small standard error of.61. With a probability of 11.1%, the economy switches from the crisis state to the bad state. Unconditionally, the tail probability of the economy being in the crisis state is estimated to be 2.76%. 3 The Model We construct a search model of unemployment embedded with credible bargaining in determining the equilibrium wage as in Hall and Milgrom (28). 6

9 Table 1 : Estimated Aggregate State Transition Matrix and Unconditional Probabilities of the Three Economic States, April 1929 December 212 This table reports the estimated state transition matrix in equation (1). The transition probabilities are defined as in equation (2), and the standard errors (in parentheses) are in equation (3). The last row reports the unconditional probabilities of the states, calculated by raising the transition matrix to the power 1,. Good Bad Crisis Good (.9) (.9) () Bad (.87) (.94) (.35) Crisis () (.65) (.65) Unconditional probability The Environment The model is populated by a representative household and a representative firm that uses labor as the single productive input. Following Merz (1995) and Andolfatto (1996), we use the representative family construct, which implies perfect consumption insurance. The household has a continuum with a unit mass of members who are, at any point in time, either employed or unemployed. The fractions of employed and unemployed workers are representative of the population at large. The household pools the income of all the members together before choosing per capita consumption and asset holdings. Finally, the household is risk neutral with a time discount factor of β. The representative firm posts a number of job vacancies, V t,toattractunemployedworkers,u t. Vacancies are filled via a constant returns to scale matching function, G(U t,v t ), specified as: G(U t,v t )= U t V t (Ut ι + V, (4) t ι )1/ι in which ι> is a constant parameter. This matching function,specified as in Den Haan, Ramey, and Watson (2), has the desirable property that matching probabilities fall between zero and one. Define θ t V t /U t as the vacancy-unemployment (V/U) ratio. The probability for an unem- 7

10 ployed worker to find a job per unit of time (the job finding rate), denoted f(θ t ), is: f(θ t ) G(U t,v t ) U t = 1 ( 1+θ ι t ) 1/ι. (5) The probability for a vacancy to be filled per unit of time (the vacancy filling rate), denoted q(θ t ), is: q(θ t ) G(U t,v t ) V t = 1. (6) (1 + θ ι 1/ι t) It follows that q (θ t ) < : An increase in the scarcity of unemployed workers relative to vacancies makes it harder to fill a vacancy. As such, θ t is labor market tightness from the firm s perspective. The representative firm incurs costs in posting vacancies. Following Mortensen and Nagypàl (27) and Pissarides (29), we incorporate a fixed component in the unit cost per vacancy: κ t κ + κ 1 q(θ t ), (7) in which κ is the proportional cost, κ 1 is the fixed cost, and both are nonnegative. The proportional cost is standard in the literature. The fixed cost captures training, interviewing, and administrative setup costs of adding a worker to the payroll, costs that are paid after a hired worker arrives but before wage bargaining takes place. The marginal cost of hiring arising from the proportional cost, κ /q(θ t ), is time-varying, but that arising from the fixed cost is constant, κ 1. Jobs are destroyed at a constant rate of s> per period. Employment, N t,evolvesas: N t+1 =(1 s)n t + q(θ t )V t, (8) in which q(θ t )V t is the number of new hires. The size of the population is normalized to be unity, U t =1 N t. As such, N t and U t are also the rates of employment and unemployment, respectively. The firm takes aggregate labor productivity, X t, as given. The law of motion for x t log(x t )is: x t+1 = ρx t + σɛ t+1, (9) 8

11 in which ρ (, 1) is the persistence, σ> is the conditional volatility, and ɛ t+1 is an independently and identically distributed standard normal shock. The firm uses labor to produce output, Y t,with a constant returns to scale production technology, Y t = X t N t. (1) The dividends to the firm s shareholders are given by: D t = X t N t W t N t κ t V t, (11) in which W t is the equilibrium wage rate. Taking q(θ t )andw t as given, the firm posts an optimal number of job vacancies to maximize the cum-dividend market value of equity, denoted S t : S t max {V t+ t,n t+ t+1 } t= E t β t [X t+ t N t+ t W t+ t N t+ t κ t+ t V t+ t ], (12) t= subject to the employment accumulation equation (8) and a nonnegativity constraint on vacancies: V t. (13) Because q(θ t ) >, this constraint is equivalent to q(θ t )V t. As such, the only source of job destruction in the model is the exogenous separation of employed workers from the firm. 2 Let λ t denote the multiplier on the nonnegativity constraint q(θ t )V t. From the first-order conditions with respect to V t and N t+1, we obtain the intertemporal job creation condition: [ [ [ ]]] κ t q(θ t ) λ κt+1 t = E t β X t+1 W t+1 +(1 s) q(θ t+1 ) λ t+1. (14) Intuitively, the marginal cost of hiring at time t equals the marginal value of employment to the firm, which in turn equals the marginal benefit of hiring at period t +1, discounted to t. The marginal benefit at t + 1 includes the marginal product of labor, X t+1, net of the wage rate, W t+1, 2 The constraint is occasionally binding in simulations from the baseline search model with Nash bargaining. Because a negative vacancy makes no economic sense, we impose the nonnegativity constraint throughout the paper. 9

12 plus the marginal value of employment, which equals the marginal cost of hiring at t +1, net of separation. Finally, the optimal vacancy policy also satisfies the Kuhn-Tucker conditions: q(θ t )V t, λ t, and λ t q(θ t )V t =. (15) Let C t denote consumption. In equilibrium, the goods market clearing condition says: C t + κ t V t = X t N t. (16) 3.2 Equilibrium Wages with Credible Bargaining To close the model, we need to specify how the wage rate, W t, is determined in equilibrium. In the standard Diamond-Mortensen-Pissarides model, the wage rate is derived from the sharing rule per the outcome of a generalized Nash bargaining process between the employed workers and the firm (e.g., Pissarides (2, Section 1.4)). Let <η<1 be the workers relative bargaining weight and b the workers value of unemployment activities. The Nash-bargained wage rate is: W t = η (X t + κ t θ t )+(1 η)b. (17) Although analytically simple, the baseline search model with the Nash wage requires an extremely high replacement ratio (i.e., the value of unemployment activities over the average marginal product of labor) to reproduce realistic labor market volatilities (e.g., Hagedorn and Manovskii (28)). We adopt the credible bargaining wage proposed by Hall and Milgrom (28). Built on Binmore, Rubinstein, and Wolinsky (1986), Hall and Milgrom place a crucial distinction between a threat point and an outside option in the wage bargaining game. Bargaining takes time. Both parties make alternating offers which can be accepted, rejected to make a counteroffer, or rejected to abandon the bargaining altogether. In the standard Nash bargaining, disagreement leads immediately to the abandonment of the bargaining game, meaning that the relevant threat point is the outside options for both parties. In contrast, in the more realistic alternating bargaining, disagreement only 1

13 leads to another round of alternating offers. The threat point is the payoff from another round of alternating offers, and outside options are taken only when abandoning the bargaining altogether. The outside option for a worker is the value of unemployment, and that for the firm is zero. During a period in which both parties engage in another round of alternating offers, the worker receives the flow value of unemployment activities, b, and the firm incurs the cost of delaying, χ>. During this period, the negotiation can also break down with a probability of δ. With this setup of the alternating bargaining game, the indifference condition for a worker when considering a wage offer, W t, from the firm is: ( ) JNt W = δj Ut +(1 δ) b + E t [βj W Nt+1 ], (18) in which J t J(N t,x t ) is the indirect utility function of the representative household, J W Nt is the marginal value of an employed worker to the household when accepting the wage offer from the employer, J Ut is the marginal value of an unemployed worker to the household, and J W Nt+1 is the marginal value of an employed worker to the household when rejecting the firm s wage offer to make a counteroffer of W t+1 in the next period. The indifference condition in equation (18) says that the payoff to the worker when accepting the wage offer from the firm, JNt W, is just equal to the payoff from rejecting the offer. After rejecting the offer, with a probability of δ, the negotiation breaks down, and the worker returns to the labor market, leaving the household with the marginal value of an unemployed worker. With the probability of 1 δ, the worker receives the flow value of unemployment, b, for the current period, and makes a counteroffer of W t+1 to the firm in the next period. The indifference condition for the firm when considering the worker s counteroffer, W t, is: S W Nt = δ +(1 δ) ( χ + E t [βs W Nt+1] ), (19) in which S W Nt is the marginal value of an employed worker to the firm when accepting the worker s counteroffer, and SNt+1 W is the marginal value of an employed worker to the firm when rejecting the 11

14 worker s offer to make a counteroffer of W t+1 in the next period. Intuitively, equation (19) says that the firm is just indifferent between the payoff from accepting the worker s offer W t and the payoff from rejecting the offer to have an opportunity to make a counteroffer of W t+1 in the next period. When rejecting the offer, the firm pays the delaying cost of χ if the bargaining does not break down. When the negotiation does break down, the firm s payoff is zero. The two indifference conditions collapse to the indifference conditions for the standard Nash bargaining when the probability of breakdown, δ, equals one. During the alternating bargaining, it is optimal for each party to make a just acceptable offer. As in Hall and Milgrom (28), we assume that the firm makes the first offer, which the worker accepts. As such, W t is the equilibrium wage, and the delaying cost, χ, is never paid in equilibrium. The equilibrium wage, W t, and the worker s counteroffer wage, W t+1, can be characterized further. First, we note that the marginal value of an unemployed worker to the household is: J Ut = b + E t [ β ( ft J W Nt+1 +(1 f t )J Ut+1 )], (2) in which f t f(θ t ) is the job finding rate. The equation says that the value of unemployment equals the flow value of unemployment activities, b, plus the discounted expected value in the next period. With a probability of f t, the unemployed worker lands a job, which delivers the value of JNt+1 W. Otherwise, the worker remains unemployed with a value of J Ut+1. In addition, the marginal value of an employed worker to the household is: J W Nt = W t + E t [ β ( (1 s)j W Nt+1 + sj Ut+1 )]. (21) The equation says that the value of employment equals the flow value of employment, W t,plus the discounted expected value in the next period. With a probability of s, the employed worker separates from the firm, and returns to the labor market as an unemployed worker with a value of J Ut+1. Otherwise, the worker remains on the job, which delivers the value of JNt+1 W. 12

15 The wage offer by the firm to the worker, W t, can be expressed as (see Appendix A): W t = b +(1 δ)βe t [ J W Nt+1 J Ut+1 ] (1 s δf t ) βe t [ J W Nt+1 J Ut+1 ] (22) Intuitively, the wage offer from the firm increases in the flow value of unemployment activities b. The second term in equation (22) says that if the bargaining does not breakdown, the wage offer also increases in the surplus that the worker would enjoy after making a counteroffer, W t+1, to the firm. From the last term in equation (22), the equilibrium wage, W t, also increases in the separation rate, s. Ass goes up, the expected duration of the job shortens. As such, the worker requires a higher wage to remain indifferent between accepting and rejecting the wage offer. Finally, W t increases in the job finding rate, f t.asf t rises, the worker s outside job market prospects improve, and the firm must offer a higher wage to make the worker indifferent. However, this impact of labor market conditions on W t becomes negligible as the probability of breakdown in the bargaining, δ, goes to zero. The wage offer of a worker to the firm, W t, can be expressed as: [ ] W t = X t +(1 δ)χ + βe t (1 s)s W Nt+1 (1 δ)snt+1 W (23) Intuitively, W t increases in labor productivity, X t, and the cost of delay to the firm, χ. A higher χ makes the firm more likely to accept a higher wage offer from the worker to avoid any delay. As W t contains a higher constant proportion because of a higher χ, W t becomes more insulated from labor market conditions. Furthermore, because W t is the flow value of J W Nt shown in equation (21), J W Nt also becomes more insulated. More important, as J W Nt enters the second term in equation (22), the equilibrium wage, W t, becomes less sensitive to aggregate conditions as a result of a higher χ. From the last term in equation (23), an increase in the separation rate reduces the wage offer from the worker to the firm, W t. As s rises, the present value of profits produced by the worker drops. To make the firm indifferent, the worker must reduce the wage offer. Also, the worker s offer, W t, increases (naturally) in the firm s surplus from accepting the offer, S W Nt+1. In contrast, the 13

16 worker s offer would be lower if the firm s surplus, SNt+1 W, from rejecting the offer to make a counteroffer, W t, is higher. However, the quantitative importance of this channel would be negligible if the breakdown probability, δ, goes to one. As such, W t increases with δ. Finally, the two parties of the credible bargaining game would agree to accept the equilibrium wage if the joint surplus of the match is greater than the joint value of the outside options, J Ut,as well as the joint present value of continuous delaying: SNt W + JNt W > max J Ut,E t β t (b χ) = J Ut. (24) The last equality holds because the flow value of unemployment, b, is higher than b χ (the delaying cost is positive). We verify that this condition holds in simulations. t= 4 Calibration and Computation We calibrate the model in Section 4.1 and discuss its solution algorithm in Section Calibration Our calibration strategy is to match the mean and the volatility of the unemployment rate in the postwar sample, before quantifying the model s performance in explaining the nonlinear dynamics documented in Section 2. Calibrating to the unemployment dynamics in normal periods seems sensible as the common practice in the existing literature. Because of the strong nonlinearity in the model, steady state relations hold very poorly in simulations. As such, we do not use these relations. Table 2 lists the parameter values for the monthly calibration of the benchmark model. The time discount factor, β, issettobee 5.524/12 = This value implies a discount rate of 5.524% per annum, which is the leverage-adjusted aggregate discount rate in the sample. 3 To calibrate the log labor productivity, we set its persistence, ρ, tobe.95 1/3 =.983 as in 3 We obtain monthly series of the value-weighted stock market returns, one-month Treasury bill rates, and inflation rates from January 1951 to December 212 from Center for Research in Security Prices. The average real interest rate (one-month Treasury bill rates minus inflation rates) is.895% per annum. The equity premium (the value-weighted market returns in excess of one-month Treasury bill rates) is on average 6.87%. Because we do not 14

17 Table 2 : Parameter Values in the Monthly Calibration for the Benchmark Model Notation Parameter Value β Time discount factor e 5.524/12 ρ Aggregate productivity persistence.95 1/3 σ Conditional volatility of productivity shocks.635 s Job separation rate.45 ι Elasticity of the matching function 1.25 b The value of unemployment activities.71 δ Probability of breakdown in bargaining.1 χ Cost to employer of delaying in bargaining.25 κ The proportional cost of vacancy posting.15 κ 1 The fixed cost of vacancy posting.1 Gertler and Trigari (29). We then calibrate its conditional volatility, σ, to match the standard deviation of labor productivity in the data. We measure the labor productivity as seasonally adjusted real average output per job in the nonfarm business sector (Series id: PRS856163) from the Bureau of Labor Statistics. The sample is quarterly from 1951 to 212. We detrend the series as the Hodrick-Prescott (1997, HP) filtered cyclical component of proportional deviations from the mean with a smoothing parameter of 1,6. The standard deviation of the detrended series is.12 in the data. With a value of.635 for σ, the implied standard deviation from the model is.13. We set the job separation rate, s, to be 4.5%, which is higher than 3.78% from the Job Openings and Labor Turnover Survey (JOLTS). However, Davis, Faberman, Haltiwanger, and Rucker (21) show that the JOLTS sample overweights establishments with stable hiring and separation and underweights volatile establishments with rapid growth or contraction. Adjusting for this bias, Davis et al. (Table 5.4) estimate the separation rate to be 4.96%. For the elasticity parameter in the matching function, ι, we set it to be 1.25, which is close to that in Den Haan, Ramey, and Watson (2). Following Hall and Milgrom (28), we calibrate the value of unemployment activities to be.71. The probability of breakdown in bargaining, δ, is.1 in our monthly frequency, and is close to Hall and Milgrom s value of.55 in their daily calibration (with 2 working days per month). model financial leverage, we calculate the leverage-adjusted equity premium as (1.32) 6.87% = 4.629%, in which.32 is the aggregate market leverage ratio of U.S. corporations reported in Frank and Goyal (28). Taken together, the leverage-adjusted aggregate discount rate in the data is 4.629% +.895% = 5.524%. 15

18 The delaying cost parameter, χ, is set to be.25, which is close to.27 in Hall and Milgrom. To calibrate the recruiting cost parameters, κ and κ 1, we target the first and the second moments of the unemployment rate in U.S. postwar sample. As noted, the mean unemployment rate in the sample from January 1951 to December 212 is 5.84%. To calculate the second moment, we follow a similar procedure in Shimer (25). We first convert the monthly series to a quarterly series by taking the monthly average unemployment rate within a given quarter. We detrend the quarterly series as the HP-filtered cyclical component of proportional deviations from the mean with a smooth parameter of 1,6. The standard deviation of the detrended series is 13.48% in the data. We end up with the recruiting cost parameters, κ =.15 and κ 1 =.1, which imply a mean of 5.75% and a standard deviation of 1.94% for the unemployment rate in the non-crisis states in the model. 4.2 Computation Because we focus on the higher moments of unemployment, the standard loglinearization cannot be used. We instead adapt the projection algorithm first developed in Kuehn, Petrosky-Nadeau, and Zhang (213) to our setting. The state space consists of employment and log productivity, (N t,x t ). The goal is to solve for the optimal vacancy function, V t = V (N t,x t ), the multiplier function, λ t = λ(n t,x t ), and the equilibrium wage, W t = W (N t,x t ), from the following five functional equations: [ [ [ ]]] κ t q(θ t ) λ(n κt+1 t,x t ) = E t β X t+1 W t+1 +(1 s) q(θ t+1 ) λ(n t+1,x t+1 ) [ ] W (N t,x t ) = b +(1 δ)βe t J W N (N t+1,x t+1 ) J U (N t+1,x t+1 ) (25) (1 s δf t ) βe t [ J W N (N t+1,x t+1 ) J U (N t+1,x t+1 ) ] (26) J U (N t,x t ) = b + E t [ β ( ft J W N (N t+1,x t+1 )+(1 f t )J U (N t+1,x t+1 ) )] (27) JN W [ ( (N t,x t ) = W t + E t β (1 s)j W N (N t+1,x t+1 )+sj U (N t+1,x t+1 ) )] (28) [ ( )] J W N (N t,x t ) = W t + E t β (1 s)j W N (N t+1,x t+1 )+sj U (N t+1,x t+1 ). (29) In addition, V (N t,x t )andλ(n t,x t ) must also satisfy the Kuhn-Tucker condition (15). 16

19 We parameterize the conditional expectation in the right-hand side of equation (25) as E t E(N t,x t ), as well as four other functions, W (N t,x t ),J U (N t,x t ),JN W (N t,x t ), and J W N (N t,x t ). As in Christiano and Fisher (2), we then exploit a convenient mapping from E t to policy and multiplier functions to eliminate the need to parameterize the multiplier function separately. 4 We approximate the log productivity process, x t, in equation (9) based on the discrete state space method of Rouwenhorst (1995). 5 Weuse17gridpointstocoverthevaluesofx t, which are precisely within four unconditional standard deviations from the unconditional mean of zero. For the N t grid, we set the minimum value to be.1 and the maximum.99. The range is sufficiently large so that N t never hits one of the bounds in simulations. On each grid point of x t, we use cubic splines with 2 basis functions on the N t space to approximate the five functions. We use extensively the approximation toolkit in the Miranda and Fackler (22) CompEcon Toolbox in MATLAB. To obtain an initial guess, we use the loglinear solution to a simplified model without the fixed matching cost. Figure 2 reports the approximation errors for the five functional equations from (25) to (29). The error for each equation is the left-hand side minus the right-hand side of the equation. The errors, in the magnitude no greater than 1 13, are extremely small. As such, our projection algorithm does an accurate job in characterizing the competitive search equilibrium. 5 Quantitative Results We examine the model s stationary distribution in Section 5.1, and quantify the model s performance in matching higher moments of unemployment in Section 5.2. Section 5.3 studies the second moments of the labor market. Section 5.4 contains nonlinear impulse response functions. Section 5.5 presents an array of comparative statics to illustrate the intuition behind the results. 4 Specifically, after obtaining the parameterized E t,wefirstcalculate q(θ t) κ t/e t. If q(θ t) < 1, the nonnegativity constraint is not binding, we set λ t =andq(θ t)= q(θ t). We then solve θ t = q 1 ( q(θ t)), in which q 1 ( ) isthe inverse function of q( ) from equation (6), and V t = θ t(1 N t). If q(θ t) 1, the nonnegativity constraint is binding, we set V t =,θ t =,q(θ t) = 1, and λ t = κ t E t. 5 Kopecky and Suen (21) show that the Rouwenhorst method is more accurate than other methods in approximating highly persistent autoregressive processes. 17

20 Figure 2 : Approximation Errors The approximation errors are for the five functional equations from (25) to (29). The error for each equation is the left-hand side minus the right-hand side of the equation. Panel A: The E(N t,x t ) error x Employment.2.1 Productivity.1.2 Panel B: The W (N t,x t ) error Panel C: The J U (N t,x t ) error x x Employment.2.2 Productivity Employment.1 Productivity.1.2 Panel D: The JN W (N t,x t ) error Panel E: The J W N (N t,x t ) error x x Employment.2.2 Productivity Employment.1 Productivity

21 5.1 Properties of the Stationary Distribution We simulate the economy for one million monthly periods from the model s stationary distribution. To reach the stationary distribution, we start at the initial condition of zero for log labor productivity and.9 for employment, and simulate the economy for 6, months. We perform a battery of diagnostics on the one-million-month simulated sample to study the model s stationary distribution. Panel A of Figure 3 plots the unemployment rate against labor productivity in simulations. The relation is strongly nonlinear. When labor productivity is above its mean of unity, unemployment goes down only slightly. However, when labor productivity is below its mean, unemployment goes up drastically. The correlation between unemployment and productivity is.654. Panel B plots labor market tightness, θ t, against productivity. Although the relation is nonlinear, the nonlinearity is not nearly as dramatic as that of unemployment in Panel A. The main source of nonlinearity in Panel B seems the nonnegativity constraint on vacancy. When the constraint is binding with lower values of labor productivity, θ t is fixed at zero. In contrast, when the constraint is not binding with higher values of productivity, the θ t -productivity relation is (virtually) linear. Figure 4 further illustrates the nonlinearity. Using the one-million-month simulated data, we report the empirical cumulative distribution functions of unemployment and labor market tightness. From Panel A, unemployment is highly skewed with a long right tail. The skewness of the unemployment rate is The 2.5 percentile, 4.73%, is close to the median of 5.32%, but the 97.5 percentile is far away, 11.34%. Also, the 1 percentile is 4.69%, but the 99 percentile is 15.65%. In contrast, Panel B shows that the empirical distribution of the labor market tightness is largely symmetric. Finally, the minimum unemployment rate is 4.55%, but the maximum rate is 47.64%. 5.2 Explaining Higher Moments of Unemployment Quantitatively Can the search and matching model explain quantitatively the nonlinear unemployment dynamics in the data, including the aggregate state transition matrix and the tail probability of the crisis state in Table 1? To this end, from the model s stationary distribution, we repeatedly simulate 1, 19

22 Figure 3 : The Unemployment-productivity Relation and the Labor Market Tightness-productivity Relation From the model s stationary distribution, we simulate one million monthly periods, and present the scatter plots of the unemployment rate versus productivity and labor market tightness versus productivity. Panel A: Unemployment Panel B: Labor market tightness Figure 4 : Empirical Cumulative Distribution Functions of Unemployment and Labor Market Tightness From the model s stationary distribution, we simulate one million monthly periods, and plot the empirical cumulative distribution functions for unemployment and labor market tightness. 1 Panel A: Unemployment 1 Panel B: Labor market tightness.8.8 Probability.6.4 Probability Unemployment Labor market tightness 2

23 artificial samples, each of which contains 1,5 monthly periods. The sample length matches the number of months in the data from April 1929 to December 212. Because crises, which are rare by definition, do not occur in every simulated sample, we split the 1, samples into two groups, non-crisis samples and crisis samples. If the maximum unemployment rate in an artificial sample is greater than or equal to 2%, we categorize it as a crisis sample (otherwise a non-crisis sample). The cutoff threshold of 2% is consistent with our empirical procedure in Section 2. Out of the 1, simulations, we have in total 17,412 crisis samples (17.41%). On each crisis sample (i.e., conditional on at least one crisis), we calculate the state transition matrix and unconditional probabilities of the states using the exactly the same procedure as in Table 1. We then report the cross-simulation averages and standard deviations across the crisis samples. 6 Table 3 reports the model output. A comparison with Table 1 shows that the model does a good job in explaining the large unemployment dynamics in the data. In particular, the crisis state is almost as persistent in the model as in the data. The probability of the economy remaining in the crisis state next period conditional on the crisis state in the current period is 86.96%, which is close to 88.89% in the data. The switching probability from the crisis state to the bad state in the model is 12.92%, which is close to 11.11% in the data. In addition, the unconditional probability of the crisis state in the model is 3.18%. Although somewhat higher than 2.76% in the data, the crosssimulation standard deviation of this estimate is 7.72%. This high standard deviation is perhaps not surprising for a tail probability estimate. As such, the model s estimate seems empirically plausible. To what a low level must the log productivity process fall to trigger a crisis with the threshold level of 2% unemployment rate? To obtain a quantitative sense, we first use an illustrative crisis sample. Panel A of Figure 5 plots the unemployment rate, and Panel C plots the log productiv- 6 We have experimented with simulating only 5, artificial samples, and the quantitative results are hardly changed under the benchmark calibration. However, we find that in comparative static experiments (Section 5.5) the results with 5, simulations can be sensitive to the increase of the number of simulations. Intuitively, the percentage of crisis samples can be small. As a result, the cross-simulation averages can be sensitive due to the small number of crisis samples being averaged over. To ensure precision in our quantitative results, we opt to work with 1, artificial samples for each of the parameterizations studied in the paper. 21

24 Table 3 : Aggregate State Transition Matrix and Unconditional Probabilities of the Three Economic States, the Credible Bargaining Model From the model s stationary distribution, we simulate 1, artificial samples, each with 1,5 months. We split the samples into two groups: non-crisis samples (in which the maximum unemployment rate is less than 2%) and crisis samples (in which the maximum rate is greater than or equal to 2%). On each crisis sample, we calculate the state transition matrix and unconditional probabilities of the states as in Table 1. We report the cross-simulation averages and standard deviations (in parentheses) across the crisis samples. Good Bad Crisis Good (.67) (.67) () Bad (.7) (.71) (.12) Crisis () (.1874) (.1896) Unconditional probability (.451) (.474) (.772) ity. A deep crisis occurs around the 3th month (the crisis sample has 1,5 months) with the log productivity drops more than three unconditional standard deviations below the unconditional mean of zero. In response, the unemployment rate hits almost 3%. Two other episodes with high unemployment rates around 13% occur shortly after the 4th month and the 7th month, when the log productivity dips just below the two-unconditional-standard-deviation bound. The example is only illustrative. To provide a more precise answer, we conduct an event study using all the crisis samples out of the 1, simulations. In each crisis sample, we define the month in which the maximum unemployment rate occurs as event time. We record both the unemployment rates and the log productivity during 6 months prior to the event. We then average the pre-event unemployment rates and the pre-event log productivity across all the crisis samples. Panel B of Figure 5 plots the average unemployment, and Panel D plots the average log productivity, both in even time. By averaging across all the crisis samples, the event study makes the unemployment-log productivity relation (conditional on a crisis occurring) more precise. Panels B and D are informative. When the log productivity falls one unconditional standard deviation below the unconditional mean of zero, the unemployment rate is about 8%. When the log 22

25 Figure 5 : An Illustrative Crisis Sample and An Event Study on Unemployment Crises Using an illustrative crisis sample, we plot the unemployment rate in Panel A and log productivity in Panel C. For the event study, in each crisis sample, we define the period with the maximum unemployment rate as event time. We record the levels of both unemployment and log productivity during 6 months prior to the event (from month 6 to ). We then average the pre-event unemployment rates and the pre-event log productivity across all the crisis samples. Panel B plots the average unemployment in event time, and Panel D plots the average log productivity in event time. In Panels C and D, the black dashed lines indicate one unconditional standard deviation above or below the unconditional mean of zero for log productivity. The red dashdot lines indicate two unconditional standard deviations above or below zero for log productivity, and the pink dotted lines indicate three unconditional standard deviations above or low zero. Panel A: Unemployment in calendar time Panel B: Unemployment in event time Panel C: Log productivity in calendar time Panel D: Log productivity in event time

26 productivity crosses the two-unconditional-standard-deviation bound, unemployment rises to 13%. The unemployment rate hits 28% when the log productivity falls three unconditional standard deviations below the mean. Using interpolation, we find that to reach the threshold of 2% unemployment, the log productivity needs to drop 2.62 unconditional standard deviations below zero. 5.3 The Impact on the Second Moments of the Labor Market The nonlinear dynamics in the search model has important implications for the second moments such as volatilities and correlations, which are the traditional focus of the literature. In particular, it can be misleading to focus only on the second moments in normal periods (non-crisis samples). The second moments in the crisis samples can deviate greatly from those in normal periods. We first report a standard set of second moments in the data as in Shimer (25). Unlike the unemployment rate, the data for vacancies and labor productivity are available only for the postwar sample. We obtain seasonally adjusted monthly unemployment (thousands of persons 16 years of age and older) from Bureau of Labor Statistics (BLS), and seasonally adjusted help wanted advertising index from the Conference Board. The sample is from January 1951 to June 26. (The Conference Board switched from help wanted advertising index to help wanted online index in June 26. The two indexes are not directly comparable. We follow the common practice in the macro labor literature in using the longer time series before the switch.) We take quarterly averages of the monthly series to obtain quarterly observations. The average labor productivity is seasonally adjusted real average output per job in the nonfarm business sector from BLS. It is customary to report all variables in log deviations from the HP-trend with a smoothing parameter of 1,6. In contrast, we detrend all variables as the HP-filtered cyclical component of proportional deviations from the mean with the same smoothing parameter. We do not take logs because vacancies can be zero in simulations when the nonnegativity constraint of vacancy is binding. (In the data, the two detrending methods yield quantitatively similar results.) Panel A of Table 4 reports the data moments in the postwar sample. The standard deviations of unemployment, 24

27 vacancy, and the labor market tightness are.119,.134, and.255, respectively. Unemployment and vacancy have a correlation of.913, indicating a downward-sloping Beveridge curve. To quantify the model s implications for the second moments of the labor market, we simulate 1, artificial samples, each with 1,5 months, from the model s stationary distribution. We again split the samples into two non-crisis samples and crisis samples, with the maximum unemployment rate of 2% as the threshold. We then apply the same empirical procedures as in Panel A of Table 4, and report the cross-simulation averages and standard deviations. Panel B reports the results conditional on the non-crisis samples (normal periods). As a calibration target, the unemployment volatility is.19, which is close to.119 in the data. Although not a direct target, the standard deviation of vacancy is.146 in the model, which is also close to.134 in the data. However, the model predicts a standard deviation of labor market tightness of.185, which is lower than.255 in the data. 7 In addition, although negative, the unemployment-vacancy correlation is.572 in the model, which is lower in magnitude than.913 in the data. Finally, in contrast to the correlation of.299 between the labor market tightness and productivity in the data, the correlation is nearly perfect in the model, likely reflecting its single-shock structure. However, focusing only on normal periods suffers from a sample selection bias that ignores the crisis samples. Panel C reports the quantitative results conditional on the crisis samples. The standard deviations of vacancy and labor market tightness are not much affected,.158 and.24 in the crisis samples versus.146 and.185 in the non-crisis samples, respectively. However, the unemployment volatility shoots up to.233, which is more than twice as large as.19 in normal periods. We apply the same procedure in Panel A of Table 4 on the unemployment rate series from April The standard deviation of labor market tightness has traditionally been the focus of the macro labor literature, stimulated by Shimer (25). Many studies argue that some modifications of the baseline search model can explain the volatility puzzle. However, reinforcing Shimer s key message, Petrosky-Nadeau and Zhang (213) argue that once the model is solved accurately with a globally nonlinear algorithm, it is difficult to explain the volatility of labor market tightness without blowing up the volatility of unemployment. In particular, the authors show that loglinearization understates the standard deviation of unemployment, overstates the magnitude of the unemployment-vacancy correlation, and misses completely the nonlinear dynamics in unemployment. Petrosky-Nadeau and Zhang make their argument in the context of Hagedorn and Manovskii (28). However, the argument is likely to apply more generally wherever a search model admits nontrivial nonlinear dynamics. 25