EC201 Macroeconomics 2, Spring 2016

University of Warwick
Thijs van Rens

Labour markets
Seminar questions - part III

As we will see in the lecture on Monday, the standard search and matching model
cannot explain the volatility of unemployment uctuations over the business cycle.
This failure of the model is called the unemployment volatility puzzle.
1. The unemployment volatility puzzle was documented in Shimers (2005) article
The Cyclical Behavior of Equilibrium Unemployment and Vacancies, which
is linked on the course website. Read the introduction of the paper and make
sure you understand what is in Tables 1 and 3. Then, summarize the puzzle in
your own words referring to the tables.
2. Simulations, as Shimer uses in his paper, are useful to evaluate the empirical
performance of the model. However, they do not help much to understand why
the model fails to match the data. For that, we need to do some more algebra.
(a) In a one shock model, the relative standard deviation of log labor market tightness, relative to the standard deviation of log labor productivity,
sd (log t ) =sd (log yt ), equals the elasticity of labor market tightness with
respect to labor productivity, d log t =d log yt . Explain why this statement
is true and why the same does not hold in a model with multiple shocks.
(b) Now derive a closed-form expression for the elasticity d log t =d log yt . In
the previous seminar, you derived a system of two equations that describe
the equilibrium of the model in the variables S and . Combine these two
equations to a single equation with as the only remaining unknown. Take
a total derivative of this equation with respect to log y and solve in order
to get an expression for d log =d log y.
(c) Look up the calibration of the model in Shimer (2005). Using this calibration, calculate the elasticity of labor market tightness with respect to labor
productivity. Compare your answer to the simulation results in the paper.
How can we see the unemployment volatility puzzle from this number?
Hint: Be careful, there are some dierences in notation between Shimers
paper and the lecture notes!
3. Hagedorn and Manovskii (2008) have criticized Shimer for using the wrong
calibration of the model. In particular, they argued that the variable b includes
not only unemployment benets, but also the utility from leisure, and that
therefore the value for b that Shimer uses is too low.
(a) If we use a higher value for b, how does that change the performance of the
model in terms of unemployment volatility?
(b) How high does b need to be for the unemployment volatility puzzle to
completely disappear? Is this value reasonable? Why (not)?

4. Costain and Reiter (2008) have criticized Hagedorn and Manovskiis criticism
on Shimer, arguing that the value for b that Hagedorn and Manovskii propose
implies an implausibly strong response of unemployment to labor market policies. The particular labor market policy they have in mind is a change in the
level of unemployment benets.
(a) Calculate the elasticity of labor market tightness with respect to b using
the calibrations of Shimer and Hagedorn-Manovskii respectively.
(b) A country with particularly low unemployment benets is the United States
of America, where unemployment benets on average are about 12% of
labor productivity. The average unemployment rate in the US is about
5%. In the UK, unemployment benets are a bit higher, at about 18%
of labor productivity on average.1 In the calibration of Hagedorn and
Manovskii, what does the model predict about the unemployment rate in
the UK? Is this a reasonable prediction?
(c) Costain and Reiter write that the model can generate su ciently large
cyclical uctuations in unemployment, or a su ciently small response of
unemployment to labor market policies, but it cannot do both. Do you
agree?

Data refer to 1995 and were taken from Table 1 in John P. Martin (1996), Measures of Replacement Rates for the Purpose of International Comparisons: A Note, OECD Economic Studies No.
26, 1996/1.