Testing Whether Unemployment Represents Intertemporal Labour Supply Behaviour

Abstract

In the Lucas-Rapping (1969) model of the labour market, fluctuations in unemployment represent individuals optimally adjusting their labour supply behaviour in response to fluctuations in wage rates over the business cycle. In this paper I propose and implement a misspecification test of the Lucas-Rapping treatment of unemployment as labour supply behaviour using panel data. This test extends previous such work with micro data by simultaneously allowing for intertemporal substitution, uncertainty and endogenous unemployment. Using the standard specification of intertemporal labour supply behaviour, I find strong evidence against this interpretation of unemployment. There are two possible interpretations of the test results. The first is that it is necessary to turn to alternative models of the labour market in which unemployed workers are off a supply function. The second is that the test results indicate the necessity of moving to more complex models of intertemporal substitution. However, given current econometric techniques and data sets, these alternative models of intertemporal substitution will be extremely difficult to test.