Markets with Search FrictionMarkets with Search FrictionAnd the Great RecessionAnd the Great Recession

Dale T. MortensenDale T. MortensenNorthwestern Northwestern

UniversityUniversityJune 22, 2011June 22, 2011

OutlineOutline

► IntroductionIntroduction► The Flows ApproachThe Flows Approach► Search EquilibriumSearch Equilibrium► The Bench Mark DMP ModelThe Bench Mark DMP Model► The Great RecessionThe Great Recession► SummarySummary

IntroductionIntroduction

►What are search frictions? What role do What are search frictions? What role do they play in the operations of markets.they play in the operations of markets.

►Examples: Buying our apartment and Examples: Buying our apartment and selling our house. Investment in time and selling our house. Investment in time and effort are required now in return for effort are required now in return for future benefits.future benefits.

►Lesson: An acceptable house, partner or Lesson: An acceptable house, partner or job is one that offers an expected stream job is one that offers an expected stream of future benefits that has a value in of future benefits that has a value in excess of the option to search for an even excess of the option to search for an even better one.better one.

The Flows ApproachThe Flows Approach

► From the viewpoint of the classical “supply and From the viewpoint of the classical “supply and demand” approach to markets, unemployment demand” approach to markets, unemployment arises only when wages are “too high.”arises only when wages are “too high.”

► But in fact, large flows of workers are finding But in fact, large flows of workers are finding (losing) jobs…in both ‘good’ and ‘bad’ times. (losing) jobs…in both ‘good’ and ‘bad’ times.

► The simultaneous existence of unemployment The simultaneous existence of unemployment and vacancies reflect the fact that it takes time and vacancies reflect the fact that it takes time to match workers and jobs.to match workers and jobs.

► Unemployment (employment) is a stock that Unemployment (employment) is a stock that tends toward a level that balances large tends toward a level that balances large inflows with large outflows.inflows with large outflows.

Labor Market FlowsLabor Market Flows

The The Matching FunctionMatching Function and the and the Beveridge CurveBeveridge Curve

► The matching functionThe matching function: A postulated : A postulated relationship between search and recruiting relationship between search and recruiting inputs and job-worker matching rate which inputs and job-worker matching rate which supposes that the job finding rate is an supposes that the job finding rate is an increasing function of the ratio of vacancies increasing function of the ratio of vacancies to unemployment.to unemployment.

► Flow balance equationFlow balance equation: Unemployment tends : Unemployment tends to the value that balances inflows and to the value that balances inflows and outflowsoutflows

► Together these explain the so-called Together these explain the so-called Beveridge Curve, a negative association Beveridge Curve, a negative association between vacancies and unemployment.between vacancies and unemployment.

The Empirical Job Finding Rate The Empirical Job Finding Rate and Beveridge Curveand Beveridge Curve

Source: Shimer (2005).

Search EquilibriumSearch Equilibrium► The ‘free entry’ conditionThe ‘free entry’ condition: Jobs are created up to : Jobs are created up to

the point where the marginal vacancy has zero the point where the marginal vacancy has zero value. Implies that fewer vacancies are created value. Implies that fewer vacancies are created per unemployed worker when the future wages per unemployed worker when the future wages promised to workers are higher given demand.promised to workers are higher given demand.

► The bargaining outcomeThe bargaining outcome: Workers and : Workers and employers share the surplus value of a match. employers share the surplus value of a match. Implies that wage demands are higher when it is Implies that wage demands are higher when it is easier to find a job – when the vacancies to easier to find a job – when the vacancies to unemployment ratio is higher.unemployment ratio is higher.

► A search equilibrium is a vacancy to A search equilibrium is a vacancy to unemployment ratio and a wage pair that unemployment ratio and a wage pair that balances these two forces.balances these two forces.

The DMP ModelThe DMP ModelWages

0Vacancies/Unemployment

Free entry condition

Bargaining outcome

The Value of a Match…The Value of a Match…

► Depends on two uncertain variablesDepends on two uncertain variables The expected stream of future match revenue.The expected stream of future match revenue. The expected rate at which this stream is The expected rate at which this stream is

discounted. discounted. ► The financial crisis affected bothThe financial crisis affected both

Households reduced consumption to replenish Households reduced consumption to replenish wealth.wealth.

Banks restricted lending and increase effective Banks restricted lending and increase effective interest rate spread that borrowers pay. interest rate spread that borrowers pay.

► The expected value of a match fell for both The expected value of a match fell for both reasons generating a drop in the vacancy-reasons generating a drop in the vacancy-unemployment ratio a move down the unemployment ratio a move down the Beveridge curve.Beveridge curve.

The Great RecessionThe Great RecessionA Negative Demand ShockA Negative Demand Shock

Wage Promise

0Vacancies/Unemployment

US Beveridge Curve Dec 2000-April 2011

Vaca

ncy

rate

Unemployment rate

The Long Slump: Has the “natural rate” The Long Slump: Has the “natural rate” of unemployment increased from 5% to of unemployment increased from 5% to

8-9%?8-9%?► ““What does this change in the relationship between What does this change in the relationship between

job openings and unemployment connote. In a job openings and unemployment connote. In a word, mismatch. Firms have jobs, but can’t find word, mismatch. Firms have jobs, but can’t find appropriate workers…the Fed does not have the appropriate workers…the Fed does not have the means of transforming construction workers into means of transforming construction workers into manufacturing workers.” …Narayana Kocherlakota manufacturing workers.” …Narayana Kocherlakota (Minneapolis Fed Pres., address, 8/17/2010)(Minneapolis Fed Pres., address, 8/17/2010)

► ““Instead, the elevated unemployment rate appears Instead, the elevated unemployment rate appears to reflect mainly cyclical factors, particularly the to reflect mainly cyclical factors, particularly the lingering shortfall of consumption spending and lingering shortfall of consumption spending and business investment.” …Chistina Romer (Former business investment.” …Chistina Romer (Former Econ Council Advisor Chair, NY Times, 4/10/2011) Econ Council Advisor Chair, NY Times, 4/10/2011)

Evidence for “Mismatch”Evidence for “Mismatch”

► The Beveridge curve has shifted out…reflecting The Beveridge curve has shifted out…reflecting the fact that it may have become harder to the fact that it may have become harder to match workers and job.match workers and job.

► Construction and finance were adversely affect, Construction and finance were adversely affect, employment fell by about only 1.3 million in employment fell by about only 1.3 million in these sectors but unemployment increased by 6 these sectors but unemployment increased by 6 million.million.

► Housing market problems (11 million mortgages Housing market problems (11 million mortgages “under water”) have reduced mobility … but “under water”) have reduced mobility … but labor demand has fallen in all regions. labor demand has fallen in all regions.

► The DMP model does suggests that mismatch The DMP model does suggests that mismatch can account for about 2 of the 5 point increase can account for about 2 of the 5 point increase in the unemployment rate. … Barlevy (2011)in the unemployment rate. … Barlevy (2011)

Beveridge Curve ShiftBeveridge Curve Shift

Source: Barlevy, Federal Reserve Bank ofChigago

Unemployment Effect of Shift Unemployment Effect of Shift

Source: Barley, Federal Reserve Bank of Chicago

Evidence for Deficient Evidence for Deficient DemandDemand

► Household investment in housing is depressed Household investment in housing is depressed by the “overhang” from by the construction by the “overhang” from by the construction boom and so households wish to reduce debt boom and so households wish to reduce debt rather than consume.rather than consume.

► Corporations are not investing in hiring and Corporations are not investing in hiring and training workers which suggests that training workers which suggests that expectations about the future prospects remain expectations about the future prospects remain depressed among employers and labor cost depressed among employers and labor cost uncertainties.uncertainties.

► However, capital expenditures are picking up However, capital expenditures are picking up reflecting a fall in equipment prices which may reflecting a fall in equipment prices which may suggest substitution of capital for labor.suggest substitution of capital for labor.

Role for Government Policy? Role for Government Policy? ► “In the Great Slump that began at the end of 2007,

low inflation resulted in an only slightly negative real (interest) rate when full employment called for a much lower real rate because of declines in demand.”

► ““Are there any policy moves available now that would Are there any policy moves available now that would speed up the slow recovery?” speed up the slow recovery?” ““Monetary policy has gone to its limits in pushing the interest Monetary policy has gone to its limits in pushing the interest

rate down.” rate down.” ““The Government seems to lack the logistical tools to expand The Government seems to lack the logistical tools to expand

government expenditures significantly and the political wind government expenditures significantly and the political wind is blowing in the wrong direction to push that lever very is blowing in the wrong direction to push that lever very hard.”hard.”

… … Robert E. Hall, 2010 AEA Presidential AddressRobert E. Hall, 2010 AEA Presidential Address

Conclusions Conclusions

►Some ‘mismatch’ exists but can’t Some ‘mismatch’ exists but can’t explain all of the data, … still it may be explain all of the data, … still it may be a problem in the future. a problem in the future.

►The real problem is that demand for The real problem is that demand for goods and services has not recovered goods and services has not recovered because real interest rates have because real interest rates have remained too high.remained too high.

►Fiscal stimulus and/or inflation would Fiscal stimulus and/or inflation would help but are not politically feasible.help but are not politically feasible.