Reallocation and the Changing Nature of Economic Fluctuations. Working Paper

The business cycle in the United States has changed in fundamental ways in the last three decades. Average labor productivity has gone from strongly procyclical to mildly countercyclical and labor market recoveries after the three most recent recessions have been weaker and more prolonged relative to earlier recessions. We consider the hypothesis that an increase in the importance of labor market mismatch during recessions can account for these changes. We build a model in which production takes place on two islands. Workers can costlessly move into and out of work within an island, but moving between islands requires passing through a longer period of unemployment. Aggregate shocks trigger relatively short-lived movements into and out of work within islands, whereas island-specific shocks lead to heightened mismatch and trigger reallocation across islands. Quantitatively, we show that a reduction in the importance of aggregate shocks—i.e. an increase in the relative importance of island-specific shocks which induce reallocation—can simultaneously account for lower output volatility, less procylical productivity, slower labor market recoveries, and behavior of labor market variables consistent with the business cycles of the last thirty years