Unemployment and Vacancy Fluctuations in the Matching Model: Inspecting the Mechanism,” Federal Reserve Bank of Richmond Economic Quarterly, Volume 91/3, Summer

T he state of the labor market, employment and unemployment, playsan important role in the deliberations of policymakers, the FederalReserve Bank included. Over the last 30 years, economic theory has led to substantial progress in understanding the mechanics of business cycles. Much of this progress in macroeconomics has been associated with the use of calibrated dynamic equilibrium models for the quantitative analysis of aggre-gate fluctuations (Prescott [1986]). These advances have mainly proceeded within the Walrasian framework of frictionless markets. For the labor mar-ket, this means that while these theories contribute to our understanding of employment determination, they have nothing to say about unemployment. Policymakers care about the behavior of unemployment for at least two reasons. First, even if one is mainly interested in the determination of employ-ment, unemployment might represent a necessary transitional state if frictions impede the allocation of labor among production opportunities. Second, job loss and the associated unemployment spell represent a major source of income risk to individuals. Over the past two decades, the search and matching framework has acquired the status of the standard theory of equilibrium unemployment.1 This theory is built on the idea that trade in the labor market is costly and takes time. Frictions originating from imperfect information, heterogeneity We wish to thank Kartik Athreya, Sam Malek, Leo Martinez, and Ned Prescott for helpful comments. The views expressed in this article are those of the authors and not necessarily those of the Federal Reserve Bank of Richmond or the Federal Reserve System. 1 For a textbook survey, see Pissarides (2000)