Aggregate and Idiosyncratic Risk in a Frictional Labor Market

Economists face difficulties explaining the strong cyclicality of US unemployment. This paper contributes both by developing modeling tools and evaluating a potentially important explanation. The paper develops a parsimonious equilibrium model of job search with aggregate productivity shocks, where i) workers face incomplete markets, and ii) wages are determined via optimal long-term contracts. Despite the large state space associated with long-term contracting, the equilibrium has a simple representation as a small system of differential equations. Incomplete markets amplify fluctuations in unemployment, and the results suggest an upper bound on how far they can go in explaining unemployment cyclicality.