Uncertainty and Labour Force Participation*

Abstract

AbstractCan an increase in uncertainty generate a fall in labour force participation? This paper supports an affirmative answer to this question. Using a structural vector autoregressive model, I show that: (i) a surge in uncertainty leads to a decrease in participation; (ii) uncertainty shocks account for a considerable proportion of participation fluctuations; and (iii) uncertainty shocks have in recent years contributed non‐marginally to participation variations. To explain these facts, I build a New Keynesian dynamic stochastic general equilibrium model with a frictional labour market, endogenous labour force and stochastic volatility. A model with flexible prices induces the expansionary effects of uncertainty on labour force participation. By contrast, a model with price stickiness can reproduce negative empirical comovements. As firms postpone hiring, the household follows a discouragement effect and responds by reducing the size of the labour force. This paper suggests that in a context of variable labour supply, labour market frictions alone do not suffice to reproduce the negative effects of uncertainty shocks. It also confirms the importance of rigid prices as an amplification mechanism for uncertainty shocks and suggests that the modelling of labour force participation has some implications on the transmission channel of uncertainty.