Heterogeneity and Cyclical Unemployment∗

We model worker heterogeneity in the rents from being employed in a Diamond-Mortensen-Pissarides model of matching and unemployment. We show that het-erogeneity, reflecting differences in match quality and worker assets, reduces the extent of fluctuations in separations and unemployment. We find that the model faces a trade-off–it cannot produce both realistic dispersion in wages across work-ers and realistic cyclical fluctuations in unemployment. ∗We thank Evgenia Dechter for her excellent research assistance; we thank Mark Aguiar, Ricardo Lagos, Iourii Manovski, and Randy Wright for helpful suggestions. 1