Productivity, Aggregate Demand and Unemployment Fluctuations

Abstract

This paper presents new empirical evidence on the cyclical behavior of US unemployment that poses a challenge to standard search and matching models. The correlation between cyclical unemployment and the cyclical component of labor productivity switched sign in the mid 80s: from negative it became positive, while standard search models imply a negative correlation. I argue that the inconsistency arises because search models do not allow output to be demand determined in the short run, and I present a search model with nominal rigidities that can rationalize the empirical findings. In addition, I show that the interaction of hiring frictions and nominal frictions can generate a new propagation mechanism absent in standard New-Keynesian models.