Utility Curvature and Unemployment Volatility

Abstract

Can we resolve the unemployment volatility puzzle (Shimer 2005) despite the cyclical opportunity cost of employment? Chodorow-Reich and Karabarbounis (2016) found that the opportunity cost of employment is highly procyclical, which poses significant challenges to the models of labor market fluctuations. Introducing procyclical opportunity cost inevitably weakens wage rigidity regardless of the exact types of wage bargaining, and it dampens the labor market volatility. We study the roles of the utility curvature and the intensive margin of labor supply, which not only induces the opportunity cost of employment procyclical but also generates additional sources of labor market fluctuations cyclical stochastic discount factor and hours worked. Our model with alternating-offer wage bargaining can replicate the observed labor market volatility, with the help of high elasticity of intertemporal substitution, despite the cyclical opportunity cost ofemployment.