Can Risk Aversion in Firms Reduce Unemployment Persistence?

This paper contributes to the growing literature that attempts to explain unemployment persistence. We show that when the economy is struck by a negative transitory (or permanent) demand or supply shock, firms can find their way back quicker to the pre-shock (or new) employment levels if they are risk-averse. The reason is that risk aversion in firms creates a self-adjusting mechanism whereby cautious firms adjust hiring and wage-setting decisions to try to regain the pre-shock employment levels and minimize fluctuations in profits. Therefore, perhaps surprisingly, risk aversion in firms is seen as a stabilizing macroeconomic force that reduces unemployment inertia.