Endogenous Separation, Wage Rigidity and the Dynamics of Unemployment

This paper shows that the Mortensen-Pissarides (MP) model requires endogenous separation to explain the volatility of unemployment. I estimate a version of the MP model with wage rigidity and permanent shocks to match productivity. The model generates sufficient volatility in unemployment, vacancies, job-finding and job-separation despite relatively low worker outside options. I then re-estimate the model while restricting the separation rate to be constant and show that, even though the estimation procedure finds the best fitting model, the model predicts too little variance in unemployment and too much variance in the job-finding rate. Based on this result I conclude that models of unemployment fluctuations need endogenous separation rates to explain unemployment fluctuations.