Search Frictions and the Labor Wedge

Abstract

We show that search frictions embedded in an RBC model primarily manifest themselves at the extensive margin. The ability to distinguish between the intensive and extensive margins, however, affects the measurement of the marginal rate of substitution (MRS). In fact, the correct measurement of the MRS, in terms of hours per worker, implies a less variable and procyclical labor wedge than the one found in Chari et al. (2007), especially at low Frisch elasticity. The main result is very robust to alternative wage determination mechanisms, even though implications for employment fluctuations may differ.