In recessions there are a series of events that take place in the labor market. Unlike market-clearing models, real life agents are not in fact homogeneous and do react over time rather than instantaneously. At the beginning of a recession, the Beveridge curve shifts out because of an increase in temporary layoffs. A quarter later, a clockwise rotation of the job creation curve moves unemployment along the Beveridge curve as firms adjust vacancies. The Beveridge curve also shifts out further because of an increase in permanent layoffs. One quarter later the labor supply reacts and the Beveridge curve shifts in slightly as quits decline but shifts out further as workers display a stronger attachment to the labor force. What follows is a graphical representation of the logical pattern of events that takes place during recessions.
Figure A: Increase In Temporary Layoffs
Figure A describes the very beginning of a recession when there is an increase in the amount of temporary layoffs. The Beveridge curve shifts out from BC0 to BC1 because of an increase in temporary layoffs. The vacancy rate moves from V* to V1 and the unemployment rate increases from U* to U1 as we move from point A to B.
Figure B: Firms Cut Back Vacancies and Job Openings
In Figure B, we are one quarter later in time and see firms adjust to the recession by cutting back the amount of job availability and vacancies. This lowers the amount of tightness present in the labor market which rotates the job creation curve JC0 downward to JC1. The vacancy rate goes from V1 to V2 and the unemployment rate increases from U1 to U2 thus moving from point B to C.
Figure C: Increase in Permanent Layoffs
In Figure C, we are still in the same quarter as Figure B. Because of an increase in permanent layoffs we see an outward shift in the Beveridge curve from BC1 to BC2 which results in the unemployment rate increasing from U2 to U3 as we move from point C to D.
Figure D: Slight Decline in Quits
Figure D depicts the 3rd quarter of the recession where labor supply finally reacts to this debacle. The Beveridge curve shifts in slightly from BC2 to BC3 as quits decline. This is understandable, in recessions uncertainty about the future is elevated, asset prices fall broadly so the wealth effect has a huge say and a job is considered a luxury so people feel the maybe I'll put off retirement until later effect. The unemployment rate moves from U3 to U4 as we move from point D to E.
Figure E: Workers have a stronger attachment to the labor force
Figure E is also in the 3rd quarter and shows an outward shift in the Beveridge curve from BC3 to BC4 as workers show a stronger attachment to the labor force. We move from point E to F and the unemployment rate increases from U4 to U5.
While only suggestive, this chain of events could indicate that labor supply responds to labor demand at cyclical frequencies. When the job creation curve rotated downward it was all labor demand, and since it remained flat shifts in the Beveridge curve translated to almost a full increase in the unemployment rate by the same amount. Although labor supply responds to labor demand when we experience high amounts of volatility (either during expansions or contractions) over the long-run however unemployment is driven by secular changes in labor supply, specifically the aging of the baby boomers and the increasing attachment of women to the labor force.
Modeling The Influence of Labor Demand on Unemployment
In the above section we followed Barnichon and Figura (2010) work and arrived at the conclusion that at cyclical frequencies (during recessions and expansions) labor demand was the prime driver behind movements in the unemployment rate. I sought to test their theory by estimating movements in the Beveridge curve and the job creation curve from 12/01/2007 to 08/01/2009. Pictured below are my results.
Figure F: Labor demand did dominate any movements in the unemployment rate during the recession
The data in the above figure comes from FRED, JOLTS and the BLS.
The first job creation curve has a slope θ = .5272 which is the mean of labor market tightness observations from 12/01/2007 to 05/01/2008. The second job creation curve has a slope θ = .16194 which is the mean of labor market tightness observations from 03/01/2009 to 08/01/2009. The power function was chosen to estimate the two Beveridge curves. For the complete details on how I derive the job creation and Beveridge curves please refer to my paper which can be found in the first post on the modern job search and matching theory of unemployment.
Figure F clearly shows that the increase in unemployment quite overwhelmingly stemmed from labor demand conditions as embodied by the downward rotation of the job creation curve. Notice that the Beveridge curve failed to shift in any significant way over this time period.