DP5340 Jobs and Unemployment in Macroeconomic Theory: A Turbulence Laboratory

Author(s): Lars Ljungqvist , Thomas J Sargent

Publication Date: November 2005

Keyword(s): discouraged worker , employment protection , job , matching , search , skills , turbulence , unemployment , unemployment insurance

JEL(s): E24 , J64

Programme Areas: Labour Economics

Link to this Page: www.cepr.org/pubs/dps/DP5340.asp

We use three general equilibrium frameworks with jobs and unemployed workers to study the effects of government mandated unemployment insurance (UI) and employment protection (EP). To illuminate the forces in these models, we study how UI and EP affect outcomes when there is higher 'turbulence' in the sense of worse skill transition probabilities for workers who suffer involuntary layoffs. Matching and search-island models have labour market frictions and incomplete markets. The representative family model with employment lotteries has no labour market frictions and complete markets. The adverse welfare state dynamics coming from high UI indexed to past earnings that were isolated by Ljungqvist and Sargent (1998) are so strong that they determine outcomes in all three frameworks. Another force stressed by Ljungqvist and Sargent (2005), through which higher layoff taxes suppress frictional unemployment in less turbulent times, prevails in the models with labour market frictions, but not in the frictionless representative family model. In addition, the high aggregate labour supply elasticity that emerges from employment lotteries and complete insurance markets in the representative family model makes it impossible to include generous government-supplied unemployment insurance in that model without getting the unrealistic result that economic activity virtually shuts down.