Economics Working Paper 19119
Abstract: Recent critiques have demonstrated that existing attempts to account for the unemployment volatility puzzle of search models are inconsistent with the procylicality of the opportunity cost of employment, the cyclicality of wages, and the volatility of risk-free rates. We propose a model that is immune to these critiques and solves this puzzle by allowing for preferences that generate time-varying risk over the cycle, and so account for observed asset pricing fluctuations, and for human capital accumulation on the job, consistent with existing estimates of returns to labor market experience. Our model reproduces the observed .uctuations in unemployment because hiring a worker is a risky investment with long-duration surplus .ows. Intuitively, since the price of risk in our model sharply increases in recessions as observed in the data, the bene.t from creating new matches greatly drops, leading to a large decline in job vacancies and an increase in unemployment of the same magnitude as in the data.