Labor Market Volatility in the RBC Search Model: A Look at Hagedorn and Manovskii’s Calibration

Abstract

The standard Diamond–Mortensen–Pissarides (DMP) labor search model generates low volatility in labor market variables relative to average labor productivity, the so-called Shimer puzzle. Hagedorn and Manovskii (Am Econ Rev 98(4):1692–1706, 2008) demonstrate that recalibrating the standard DMP model to be consistent with the small vacancy posting cost and wage elasticity observed in the data can resolve the Shimer puzzle. They close by stating that their calibration strategy would also resolve the Shimer puzzle in the real business cycle (RBC) search framework. In this paper, we examine their claim and find that their strategy resolves the Shimer puzzle in the RBC search model for linear preferences (with risk neutrality and infinite Frisch elasticity of labor supply), but falls significantly short for more standard assumptions on the degree of relative risk aversion (of 1–2) and Frisch elasticity (of 2–3), in line with empirical estimates. While our conclusions are based on highly accurate solutions using the Generalized Stochastic Simulation Algorithm, we also assess the accuracy of a frequently used linearization method and its implications for the assessment of labor market volatility.