Can Market-Clearing Models Explain U.S. Labor Market Fluctuations?

Abstract

Throughout the past two decades, market-clearing models of the business cycle have been praised for their ability to explain key empirical features of the post-war U.S. business cycle. Real business cycle (RBC) theory shows that in a model grounded in microeconomic foundations, disturbances to national productivity can explain how aggregate variables such as GDP, consumption and investment behave over time, relative to each other. One of the primary weaknesses of the standard RBC model, however, is its inability to account for some important aspects of U.S. labor market fluctuations. In this article, Victor E. Li summarizes important U.S. business cycle facts and examines how and why these market-clearing models have so much difficulty explaining the mannner in which these facts pertain to the labor market. Li then develops a simple market-clearing framework that demonstrates how a more realistic treatment of unemployment and incomplete risk-sharing may provide an alternative approach to better account for these labor market facts. In particular, Li looks at the situation where the risk of being unemployed cannot be completely shared across all individuals when there are unexpected aggregate economic shocks.