Imperfect information, lagged labour adjustment, and the Great Moderation

Abstract

This paper first documents the increase in the time lag with which labor input reacts to output fluctuations (the labor adjustment lag) that is visi- ble in US data since the mid-1980s. We show that a lagged labor adjustment response is optimal in a setting where there is uncertainty about the persis- tence of shocks and where labor input is costly to adjust. We then present evidence that both the nature of shocks hitting the economy as well as labor adjustment costs may have changed during the 1980s in a direction that could explain the observed increase in the lag. Finally, we argue that the increased labor adjustment lag has the potential to explain some macroeconomic puz- zles that characterize post-1984 US data, such as the reduced procyclicality of labor productivity and the reduction in output volatility (known as the Great Moderation). Key words: imperfect information, labor adjustment, jobless growth, option value of waiting, Great Moderation JEL-classifications: E24, E32, J23, J24