Project outline

Research theme

“The impact of the interest rate on labour market volatility”

Motivation

The labour market is currently a hotly contested topic in Economics. After being presented
with the Diamond-Mortensen-Pissardes (DMP) model in my second year of studies I felt I
still had many unanswered questions, especially related to ‘The Shimer Puzzle’. It was
heartbreaking to see such a wonderfully crafted model be almost reduced to insignificance
because it cannot explain the volatility of two of the main components of the labour market,
unemployment and vacancies. On a more personal note, my own father was made
unemployed during the financial crisis of 2007 and it took him four years to get back into the
labour force. During the financial crisis it was clear to see the struggle involved across the
world, where individuals would like to work but are not able to do so. To be able to add my
own contribution to the literature on labour markets, I feel I would be making a very small
step in the right direction towards mitigating this waste of resources.

Objective and Methodology

I will be simulating a discrete time version of the model presented in Hall (2017) using a log
linearised model to approximate a system of nonlinear difference equations. I will be aiming
to find out how the interest rate affects labour market volatility. As Hall (2017) mentions in
his paper, a higher discount implies a lower present value of the benefit of a new hire to an
employer. When the incentive for job creation falls then unemployment rises, thus high
discount rates imply high unemployment. I would like to test this claim using a more
conventional simulation approach.

Contribution to the literature and research significance

Hall’s (2017) paper is very new, and therefore there has not been the chance for a profound
critique of his work. I would like to try to offer my own validation of his findings using a more
conventional simulation approach, which would either reinforce his argument or offer some
caution about his results and conclusions.

 Literature Review

It was Shimer (2005) in his paper looking at the cyclical behaviour of equilibrium
unemployment and vacancies, who was the first to observe that the standard search and
match model failed to produce the necessary fluctuations in unemployment and job
vacancies in response to shocks. Shimer (2005) calculated that in the United States, the
standard deviation of the vacancy-unemployment ratio is nearly 20 times as large as the
standard deviation of average labour productivity, despite the model predicting that these
should be approximately equal. This is known as ‘The Shimer Puzzle’.

In the literature, there has been an intense debate trying to solve ‘The Shimer Puzzle’; the
most recent work which was carried out by Hall (2017), builds upon work by Mukoyama
(2009), who in his paper concluded that an extremely large variation is discount factor is
required to account for the labour market volatility we observe. Hall (2017) took this one step
further by showing in his model that a volatile stochastic discount factor - inferred from the
stock market along with a small contribution from productivity growth - accounts for most of
the observed movements of labour market tightness and unemployment. This contrasts the
standard model described in earlier literature such as Rogerson et al. (2005) where
productivity was the primary driver of fluctuations. Hall (2017) illustrates why higher
discounts lead to high unemployment and this is primarily down to a higher discount factor
reducing the present value of the benefit of a new hire to an employer, thus the incentive for
job creation falls and unemployment rises, which is all perfectly plausible according to the
standard model.

Bezdresch et al. (2009) conducted some empirical work to show the relation between labour
hiring and the annual risk premium, laying some of the foundations to show that the labour
market and financial market are significantly dependent upon each other, just as Hall (2017)
has tried to model. However, Bezdresch et al. (2009) offered the perspective from a firm’s
point of view and just as labour market frictions can have an impact on asset prices, risk
market premiums are an important determinant of hiring decisions. Therefore, we have
evidence to support the importance of discount rates from a worker’s perspective provided
by Mukoyama (2009) and also the firm’s perspective by Bezdresch et al. (2009).

Kilic and Wachter (2015) credited labour market volatility to the presence of a disaster risk
which is factored into the discount rate applied to future hires. This seems unrealistic due to
the persistence of high and lingering unemployment, even when the worst of the crisis is
over. Hall (2017) highlighted that there is a lack of agreement on why the volatility of the
discount factor is high.

Hall (2017) incorporates credible bargaining as part of his argument, reinforcing his earlier
work with Milgrom (2008). As suggested in their joint paper, the credible bargaining model
leads to weaker feedback between current unemployment levels and current wages,
therefore when the labour market is hit with a shock, the credible bargaining model delivers
more variation compared to the Nash bargaining model. The problem with the Nash
bargaining model according to Hall and Milgrom (2008) is that the Nash bargained wage is a
weighted average of the applicant’s productivity in the job and value of unemployment and
this cannot explain realistic unemployment fluctuations.

Merz and Yashiv (2007) also investigate the link between the financial market and the labour
market but take the view that the value of hiring is included in the market value of the firm.
They conclude that investment and hiring asset values are forward looking, expected
present value expressions, therefore they exhibit relatively high volatility; similar to the
behaviour of financial variables with an asset value nature. As a result, due to this asset
value nature it is reasonable to assume that discount rates create a large amount of volatility
as this is the primary variable affecting present values. Hall’s (2017) paper also relies upon
the strong assumption that the market value of a firm arises solely from its investments in
plant, equipment and employees. However, the similarities end there as Hall (2017) goes
one step further to make a weaker assumption that corporate profits arise from many
sources, including capital stocks.

Kehoe, Midrigan and Pastorino (2015) reparameterize the standard model so that it is in
accord with the micro evidence on returns to tenure and experience. They found that in their
new model, employment responds much more to productivity, which potentially means that
there may be an issue with calibration that is not enabling productivity to account for a large
amount of volatility. Hall (2017) still considers productivity to be a critical factor in his model
but potentially calibration may be reducing the effect of productivity in the standard
Diamond-Mortensen-Pissarides model. However, Kehoe, Midrigan and Pastorino (2015) still
support Hall (2017) through the use of ‘backloaded’ returns that increase the sensitivity of
the model to discount rates. In their paper, human capital acquired in any given match can
be used in future matches, so working is a long lived investment of which the returns are
sensitive to changes in discount rates.

Finally, it is also interesting to note that some economists have decided to avoid the debate
altogether. For example, in the Farmer (2012) paper, he looked at the relationship between
the levels of the stock market and unemployment, but did not adopt the views of the modern
literature and instead opted for the traditional view of the standard labour market model. This
is particularly pertinent with regard to the start of this critical analysis where I highlighted the
heated nature of the debate on labour markets. Thus, in some cases it is easier to simply
use the standard model and ignore any potential rebuke from using an outdated or
incorrectly specified model.

References

Bazdresch, S., Belo, F. and Lin, X. (2009). Labor Hiring, Investment and Stock Return Predictability
in the Cross Section. SSRN Electronic Journal.

Farmer, R. (2012) “The Stock Market Crash of 2008) Caused the Great Recession: Theory and
Evidence.” Journal of Economic Dynamics and Control 36 (5) : 693-707

Hall, R. (2017). High Discounts and High Unemployment. American Economic Review, 107(2),
pp.305-330.

Hall, R. and Milgrom, P. (2008). The Limited Influence of Unemployment on the Wage
Bargain. American Economic Review, 98(4), pp.1653-1674.

Kehoe, P., Midrigan, V., Pastorino,. (2015). Discount Rates, Learning by Doing and
Employment Fluctuations. New York: New York University. Available at:
http://www.virgiliumidrigan.com/ [Accessed 28 Nov. 2017].

Kilic, M. and Wachter, J. (2015). Risk, Unemployment, and the Stock Market: A Rare-
Events-Based Explanation for Labor Market Volatility

Merz, M. and Yashiv, E. (2007). Labor and the Market Value of the Firm. American
Economic Review, 97(4), pp.1419-1431.

Mukoyama, T. (2009). A Note on Cyclical Discount Factors and Labour Market Volatility.
[ebook] Charlottesville: University of Virginia. Available at:
https://sites.google.com/site/toshimukoyama/ [Accessed 28 Nov. 2017].
Rogerson, R., Shimer, R. and Wright, R. (2005). Search-Theoretic Models of the Labor
Market: A Survey. Journal of Economic Literature, 43(4), pp.959-988.

Shimer, R. (2005). The Cyclical Behavior of Equilibrium Unemployment and Vacancies.