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Asset Prices and Unemployment Fluctuations

Staff Report 591 | Published January 8, 2020

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Patrick J. Kehoe Monetary Advisor
Pierlauro Lopez Federal Reserve Bank of Cleveland
Virgiliu Midrigan New York University
Elena Pastorino Visiting Scholar
Asset Prices and Unemployment Fluctuations


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 fluctuations in unemployment because hiring a worker is a risky investment with long-duration surplus flows. Intuitively, since the price of risk in our model sharply increases in recessions as observed in the data, the benefit 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.