The Modern Job Search and Matching Theory of Unemployment

Hello world,


I know that I haven't blogged in a while and that my fans are demanding some posts.  What I have decided to do is post this paper I have been working on all semester for my labor economics class. My underlying goal was to make something initially so abstract ( i.e. Modern Job Search and Matching Theory of Unemployment) seem intuitive and simple so that the general public can understand aspects of modern macroeconomics.

In order to achieve my goal I therefore encourage anyone who reads this to download the paper. The paper is on the Modern Job Search and Matching Theory of Unemployment which describes unemployment in terms of search and matching frictions.  I take the following from my abstract and introduction so that you get the general idea:


From Abstract:


This paper presents The Modern Search and Matching Theory of Unemployment in a manner that clears up most of the confusion surrounding it. The theory is broken up into sections analyzing the wage-setting curve, vacancy-supply curve, job creation curve and the Beveridge curve. Additionally, several major applications of the theory including the effects of search intensity, the minimum wage and unemployment compensation are reviewed. A look at the timing of movements in the unemployment rate during recessions is also provided. The hypothesis that labor demand is the main driving force behind the unemployment rate is tested and matching efficiency is also empirically estimated. The analysis concludes with an early search model and the appendix covers the mathematical form of the main model covered in the body of the paper.


From Introduction:



Among academics and professional economists alike the modern job search and matching theory of unemployment has become the industry wide norm for analyzing fluctuation and movements within the labor market. The contribution it has made to modern macroeconomics is revolutionary and its implications will take years to fully comprehend and appreciate. Standing at the forefront of modern macroeconomic research it has already received much praise as witnessed with the recognition of the theories founding fathers Christopher A. Pissarides, Peter A. Diamond and Dale T. Mortensen by The Royal Swedish Academy of Sciences.


Unfortunately, it is tendency of undergraduate economics departments to lag in teaching the revolutionary work of their graduate school counterparts. Even with the marvelous results and realistic nature of the modern search and matching theory of unemployment this time seems to be no different. Undergraduates everywhere are encouraged to analyze the labor market with neoclassical assumptions about market clearing, homogeneous agents and perfect information. Then they are told to peruse through the Bureau of Labor Statistics' Employment Situation only to observe the civilian unemployment rate persist around nine percent. A model as realistic as the modern job search and matching theory of unemployment has implications that are reinforced to students of economics by the news, while a model which calls for markets to always clear lacks that crucial element of believability. The time for a clear explanation must be without further delay. 


This paper seeks to explore the the modern job search and matching theory of unemployment by placing the Beveridge curve at the center of the analysis. Applications of the model will be brought to light. These include analyzing the effects of search intensity, the minimum wage, and unemployment insurance benefits on the unemployment rate. Additionally, a graphical analysis will be provided to shed light on why and when the unemployment rate moves during a recession. Using the Job Openings and Labor Turnover Survey and FRED, the hypothesis that labor demand drives movements in the unemployment rate during recessions is tested. 


Moreover, insights from behavioral economics are used to discuss some possible labor market policies that take advantage of this theory and individuals observed behavioral tendencies. Lastly an early and very microeconomic model of job search is brought to light to stress the importance of imperfect information in job search and the impacts of a workers reservation wage on their duration of unemployment.  

 A link to download the paper is found here.

A Slight Abstraction: A Very Quick Thought On Tradeoffs

In neoclassical labor economics theory- there is a supposed tradeoff between work & leisure.  There is a comparable trade off between sex and leisure(which is less working & less cash to enjoy life).  Where work=sex, ceterus paribus.  Because work -ceterus paribus- is equivalent to status which is the set={money, power, cars, sex  & gucci}.  Therefore, status must then be the tradeoff with leisure.  Since sex is an element of status, sex is therefore traded with leisure.  Although one could make the obvious argument that sex is in the leisure set as well.  It would then be an element of the intersection of the two sets.  But that would require no tradeoff between sex and leisure, ceterus paribus & since sex is a hassle to attain i would argue it is inversely related to relaxing.  As leisure goes up elements in the status set {money, bossness, cars , hoes} are sacrificed and vice versa.  This all implies that status is not free, which in fact it isn't.  Men have long known that a way to a woman is through proper courtship.  Gifts, flowers, valentines day, wedding rings, flashy cars and numerous other things suggest that this is so.  

This is a guest post from Hunter Richards, who blogs about online accounting software and other business technology for Software Advice. This article was originally published on Hunter's blog here.

Despite the tremendous benefits of information technology (IT), it comes at a human cost - the displacement of less-skilled employees. As software and systems automate an increasingly large portion of business processes, the displacement is affecting a wider set of workers. So despite an improving economy, 9.5% unemployment might last longer than many think.

Here we walk through a fairly simple story of man versus machine. It’s not a new story, but we went to the effort of pulling together and visualizing the relevant data.

Looks like it's time to hit the books.

IT spending has risen dramatically over the last 40 years...

IT spending has steadily risen since 1970. Trendlines and new opportunities like cloud computing suggest that the current dip in spending is only temporary.

...making us more productive...

Technology has made labor more productive. There’s a long-term upward trend in labor output rates, and it isn’t slowing down.

...which has led to rapid growth in corporate profits.

The resulting productivity has been great for business - greater productivity means higher profits. But these profits don’t benefit everyone. They accrue to the executives and shareholders.

IT is slowly replacing many functions. There’s an ever-widening divide in the labor market between skilled occupations and what one might call “low-level jobs” - simple clerical roles, plant-floor workers, and low-level support roles.

While national unemployment rates have ebbed and flowed...

...the uneducated are consistently left behind...

This polarization between highly-skilled and less-skilled workers is part of what’s eroding the middle class, pushing more and more people into the low income bracket.

...and wealth has shifted toward the highest earners.

The less-educated workers who manage to keep their jobs are falling further and further behind in the national income distribution as the relative value of their services declines.

Alas, high-tech industries are growing...

So how can you avoid being replaced by a machine? You’ll need to be one of the people who work in an advanced field that still requires highly-skilled human capital. Take the IT field, for example. The Tech Pulse Index tracks the growth of national economic activity in technology by combining data on employment, investment, production, shipments, and consumption. The Tech Pulse Index has risen sharply (with the exception of the dot-com bust around the year 2000), reflecting continued demand for high-tech workers. The same is true in other engineering disciplines, healthcare and finance.

...but an advanced education is required.

Are we educating people enough to slow the widening of labor market gaps? The graph above shows the percentage of all 18- to 24-year-olds enrolled in degree-granting institutions since 1970. There’s an upward trend, but is it growing fast enough?

IT is good for society in the long term, but it’s a double-edged sword when considered together with labor market trends. Sure, the current economic despair owes its severity to many different issues - offshoring of jobs, the real estate collapse, and the national debt are just a few - but education and income disparities are long-term problems that demand attention. We must align education growth with productivity growth to close these gaps.

Janet Yellen and the Fed's New Approach to Asset Bubbly

     I love Janet Yellen because she is an academic and a Hyman P. Minsky follower on the Federal Reserves Board of Governors.  In a recent speech titled "The Federal Reserve's Asset Purchase Program", Yellen breaks down the Fed's decision to engage in a second round of asset purchases while offering the best research available.  She delves into the beverage curve- which is the relationship between unemployment and job vacancies- to talk about both structural and cyclical factors affecting unemployment.  Additionally, she details the Fed's new attempts at monitoring quantitative easing effects on credit flows and asset bubbles.  This is a revolutionary and remarkable change in procedure at the Fed because before this crises the Fed would have completely denied looking at asset price movements and credit in making its decisions.  This signals a significant shift in the attitude and mindset that recognizes that markets are not always efficient or rational, especially when it comes to asset prices.  In evaluating the dangers of the Fed's latest round of quantitative easing, Yellen mentioned the following asset price and credit indicators:

With respect to the stock market:

"In the stock market, for example, price-to-earnings ratios, by some measures, remain below their averages over the past several decades, and other valuation measures also indicate that equity prices are not significantly out of alignment with past norms."

Then looking at the Price-to-rent ratio for the housing market:

"In the real estate market, price-to-rent ratios for both residential and commercial real estate are now within a reasonable range of their long-run averages, in contrast to the severe misalignment that occurred prior to the crisis. Again, there is little sign here of imbalances relative to fundamentals, at least if history is used as a guide."

In the Bond market we have seen the obvious bubble created by the fed when it intervenes into the market and buys up treasuries:

"In fixed-income markets, narrow risk spreads and risk premiums could be signs of excessive risk-taking by investors, and indeed spreads on corporate bonds have dropped dramatically since the financial crisis, as the economic outlook has improved and investor sentiment has picked up. Risk premiums on nonfinancial corporate bonds, as measured by forward spreads far in the future, are relatively low compared with historical norms, although other indicators for this market do not point to overvaluation." 

Yellen even mentions identifying financial imbalances by focusing more directly on measuring credit flows and exposure to credit risk! In this area the risks are mute:

"Thus, there is little evidence that financial institutions are significantly expanding the level of credit and liquidity provided to households and businesses on net. Indeed, given the current very low level of interest rates and the continuation of the economic recovery, credit flows remain stubbornly sluggish."

The Fed even created a new survey called the Senior Credit Officer Opinion Survey on Dealer Financing Terms to monitor leverage:

"To monitor leverage provided by dealers to financial market participants, last June the Federal Reserve launched the Senior Credit Officer Opinion Survey on Dealer Financing Terms. This survey provides information on credit terms and availability of various forms of dealer-intermediated financing, including funding for securities positions and over-the-counter derivatives. The survey results suggest that over the past several months there has been some easing of terms applicable to financing for a range of counterparty types and many types of collateral, as well as an increase in demand from clients to fund most types of securities. These results indicate that the availability and use of leverage by nonbank financial institutions increased somewhat last year."

The Fed is on track to be extremely successful in the long-run.  Although, the additional asset purchases are a dangerous move given that the Fed has created and set in motion a bond bubble.  The asset purchases explicitly say to the financial markets that the Fed will not be afraid to use this tool in the future, which may in itself create a moral hazard for the bond market.  The thing that I love best about Janet Yellen's speech must be the explicit statement about using adaptive regulation to target financial imbalances versus using the extremely blunt federal funds rate.  Janet wants to work closely with other regulators to monitor systemic risk and nip asset inflation in the bud.  I wrote about this a while back (June 21,2010 to be exact)  thus making me especially delighted that someone on the board has formed the same views (albeit independently):

"We are working with other regulators to make the financial system more robust and are attentive in our supervision to developments that may affect systemic risk. If evidence of financial imbalances were to develop, I believe that supervision and regulation should provide the first line of defense so that monetary policy can concentrate on its longstanding goals of price stability and maximum employment. That said, we cannot categorically rule out using monetary policy to address financial imbalances, given the damage that they can cause."

The Employment Situation

The employment situation is by far the most significant of all the major economic indicators.  The reasons include the data timeliness as it is literally released one week after the month being looked at and also the fact it includes data on household earnings and the job market which determines future spending.  

First thing to note is that the employment situation is broken up into two sections; the household survey and the establishment (or payroll) survey.  The household survey is essentially the government contacting 60,000 people each month, and from this data the civilian labor force along with how many of these people actually have jobs is calculated.  Furthermore, it is from the household survey that we derive the widely reported unemployment rate.  The establishment survey is considered to be a better employment measure than the household survey as its data comes directly from businesses, not households.  Each month the Bureau of Labor Statistics gets in touch with 400,000 companies and government agencies which are responsible for the employment of 40 million or so workers.  The following is a graph of total nonfarm payrolls (in thousands):

 One important thing to notice is the average number of hours worked in a week.  If the number of weekly hours increases for three consecutive months (aka the three month moving average is increasing), it is a strong signal that companies will soon accelerate hiring.  The same is true vice-versa, meaning if the three month moving average is declining then expect layoffs and cutbacks.  From the BLS employment situation report:

"The average workweek for all employees on private nonfarm payrolls
held at 34.3 hours in December. The manufacturing workweek for all
employees declined by 0.1 hour to 40.2 hours, while factory overtime
remained at 3.1 hours."

As the following graph shows average weekly hours have remained steady, indicating the economy is not going to be doing much on the hiring front:

Overtime hours are noteworthy because in times of economic uncertainty, rather than hiring new workers companies might ask their employees to work additional hours.  The catch is that overtime hours can be costly for a firm and so if there is a consistent upward trend in hours for 3 months firms are put under pressure to hire again. Changes in overtime manufacturing hours are considered particularly sensitive to fluctuations in demand. As the following graph shows over time hours have indeed increased but are still below pre-recessionary levels:

One of the best things to look at when seeking to reveal trends in future employment is temporary employment.  Companies often prefer to employ temporary help, due to lingering uncertainty I suppose, before taking the big daddy all in expensive step of permanently hiring and training new full-time employees.  Temps are cheaper and they give firms flexibility to add and reduce staff during these most certainly uncertain times.  The following graph paints the picture that firms are adding temps, but we have some time yet to see if this translates into any permanent hiring.

The source for the graph above is indeed the BLS and the data was extracted from the best site ever created- FRED.

The most recent employment situation reveals that the unemployment rate edged down to 9.4% and nonfarm payroll employment increased by a wompish 103,000 -considerably below expectations of around 150,000.  The drop from 9.8 to 9.4 in December, on the surface seems pretty great, however it may just reflect people leaving the labor force because they no longer receive unemployment benefits and consider themselves hopeless.  The WSJ real time economics blog highlights this change:

"The big drop in the overall unemployment rate and the U-6 measure was primarily due to a decline in the number of unemployed, which fell by 556,000 in December. That’s good news since the number of people who are employed increased by nearly 300,000. But that still leaves over 250,000 workers leaving the labor force altogether. That likely means a substantial part of the drop was due to workers giving up. Anyone unemployed over 99 weeks has no access to unemployment benefits and many lose access even earlier. Once those benefits expire, the unemployed may stop considering themselves part of the labor force."

Sudeep Reddy of the Wall Street Journal's Real Time Economics Blog makes at least one other interesting point claiming that at this pace we will have to wait until the 2020's before the unemployment rate hits 5% again:

"The economy lost almost 8.4 million jobs from December 2007 to December 2009. It added 1.1 million jobs in 2010. At December’s pace, just replacing the rest of those lost jobs would take 70 more months — roughly six years, taking us to November 2016...But the economy also needs to add 100,000 to 125,000 jobs a month just to keep pace with growth in the labor force... Even employment gains close to October’s pace (210,000 jobs) would take us into the next decade before seeing the unemployment rate back near 5%."

That's a bummer.  For considerably more analysis on the employment situation please read the Wall Street Journals Real Time Economics Blog. 

Initial Claims for Unemployment Insurance and the Business Cycle

The reliability of initial claims in predicting employment fluctuations depends on the state of the business cycle.  While generally very useful in forecasting employment during recessions, very early on in recovery however, they lose their predictive value.  This is because initial claims for unemployment are an important measure of layoffs, but changes in overall employment depend on both layoffs and hiring. 

Employment can fluctuate for one of three reasons: firms are hiring workers, firms are laying off workers, or workers decide to quit.  Claims provide us with a window into the layoff side of the labor market, but in order to paint the whole picture we need to also analyze the other main component- hiring- over the course of the business cycle.   

During recessions a strong inverse relationship exists as initial claims rise and hiring receeds.  During upturns, however, the systematic relationship between claims and hiring found during recessions virtually disappears, suggesting that layoffs are being driven by factors that differ from those driving hiring decisions.  Since hiring overshadows claims and claims move independently of hiring, claims alone cannot tell us much about the overall direction in employment. 

Thankfully, economic theory does not leave us hanging.  Because training new employees can be expensive, firms are often reluctant to fire workers as a way to cut costs and will tend to do so only when no other option is available.  During expansions, when hiring rates are high, firms are more likely to adjust to a slowdown in economic activity by hiring fewer workers than by laying off existing workers.  In contrast, during recessions, many firms seek to reduce the number of employees on their payrolls.  In implementing such cutbacks, these firms will be forced to hire fewer new workers and to lay off part of their existing workforce.

In light of this information we should be looking at hiring to determine where employment will be heading, not just initial claims.  So even though initial claims came in under 400,000 all that really means is that firms are laying off less workers versus hiring a ton of new workers.  Here is a graph of total private hires (right axis in thousands) vs. a 4-week moving average of initial claims (number on left hand side).  

Although hiring has yet to come up significantly it is important to note the data cuts off after october so it maybe misleading.  Nonetheless even with 'fresher' data we could still assume that we have a long way to go before our precious unemployment rate is brought down.  Another important indicator to look at when deciding whether the employment picture might turn is average weekly hours, but I'm feeling too lazy to put a graph of that up.        

References:

All the data for my graph came from FRED (Duh!).

McConnell , Margaret M. “Rethinking the Value of Initial Claims as a Forecasting Tool”. From the Federal Reserve Bank of New York’s Current Issues In Economics and Finance; November 1998, Volume 4/Number 11. 

A graphical illustration of quantitative easing & the bond market rejection

On November 3, 2010 the F.O.M.C. announced that it would be purchasing 600 billion in treasuries on a schedule of $75 billion a month till the second quarter of 2011.  When the Fed does quantitative easing it is mostly just purchasing 2 to 10 year nominal U.S. treasury bonds.  The main channel through which quantitative easing is supposed to work is called the portfolio effect.  This works as follows, the Fed purchases treasuries therefore reducing the total supply on the open market.  The supply curve for treasuries in figure 1 shifts to the left from BS0 to BS1 as we move from A to B. Notice that their yield or the interest rate return falls from R0 to R1.  The fall in this interest rate causes investors to seek higher returns in assets with comparable maturities and interest rate risk structure.  A 10 year AAA corporate bonds yield would then be more attractive relative to 10 yr nominal treasuries and their demand curve in figure 2 would shift right from DCB0 to DCB1.  The lower interest rate on these corporate bonds would make it easier for firms with access to the capital markets to issue debt for long term business investment.

It is now January 4^th, 2011 and we wish to see if the fed’s plan to spur long term investment is doing what the portfolio effect would suggest.  Figure A is the same as before with the fed reducing the total available supply of treasuries on the market. 

 

Figure B & C: The bond market rejects the purchases so the demand for treasuries shifts to the left from BD0 to BD1 and we move from point B to point C in figure B.  The Feds actions are completely negated in the treasury market.  Since AAA rated corporate bonds are closely tied to treasuries, the portfolio effect has also worked the other way.  This was witnessed when the demand for corporate bonds shifted to the left.  This is represented in figure C with the movement from A to B and a higher interest rate as the demand curve shifted from DCB0 to DCB1.  The higher interest rate discourages debt issuance for the support of long term investment.

As one can see from the following chart, this is exactly what occurred.  The bond market rejected the fed’s actions and started a massive sell off which lead to the steepening of the yield curve.

The following figure D, wraps up the story.  With the Fed agreeing to purchase 600 billion more treasuries, people may be feeling that bonds are overpriced and decided to take their money elsewhere, mainly the stock market.  The less risk adverse attitude and hope for a higher return led people to dump their bonds and buy other assets like equities.  The demand for equities in the diagram below shifts to the right from D0 to D1 as it moves from point A to B. 

The following chart describes that this is exactly what happened as the yield curve steepened so did the S&P rage.