Is Labor Supply Important for Business Cycles?

Abstract

We build a general equilibrium model that features idiosyncratic shocks, search frictions and an operative labor supply choice along the extensive margin. We use this model to study the implications of several aggregate shocks for the behavior of labor market aggregates and flows, and in particular the role of labor supply. While shocks to only job finding and job loss rates can account for unemployment fluctuations, the presence of labor supply responses implies that they account for only a small fraction of employment fluctuations and have counterfactual predictions for participation. A model that features shocks to the return to market activity in addition to the job finding and job loss rates accounts for fluctuations in employment and unemployment as well as the main patterns found in the labor market flows. Employment fluctuations in this model are driven by labor supply responses.