Uncertainty and unemployment

Abstract

This paper studies the impact of time-varying idiosyncratic risk at the establishmentlevel on unemployment fluctuations over 1972–2009. I build a tractable directed searchmodel with firm dynamics and time-varying idiosyncratic volatility. The model allowsfor endogenous separations, entry and exit, and job-to-job transitions. I show that themodel can replicate salient features of the microeconomic behavior of firms and thatthe introduction of volatility improves the fit of the model for standard business cyclemoments. In a series of counterfactual experiments, I show that time-varying risk isimportant to account for the magnitude of fluctuations in aggregate unemployment forpast U.S. recessions. Though the model can account for about 40% of the total increasein unemployment for the 2007–2009 recession, uncertainty alone is not sufficient toexplain the magnitude and persistence of unemployment during that episode.