Do general equilibrium effects matter for labor market dynamics?

Abstract

Business cycle models with search-matching frictions are studied to evaluate the importance of general equilibrium effects generated by movements in the stochastic discount factor and the income effect on labor supply. Without variable work hours, the general equilibrium effect works only through the stochastic discount factor and is quantitatively very weak. With variable work hours, the income effect generates procyclical movements in the value of leisure and the marginal hourly wage rate. This effect is sizable and dampens labor market fluctuations. • We evaluate the importance of general equilibrium effects over the business cycle. • This study examines business cycle models with labor market frictions. • The labor-market effect of the stochastic discount factor is quantitatively weak. • The income effect through hours of work dampens labor market fluctuations. • Models with endogenous hours are vital for understanding labor market fluctuations.