Why Labor Force Participation (Usually) Increases When Unemployment Declines

Unemployment and labor force participation (LFP) are usually negatively correlated over the business cycle, that is, once the unemployment rate starts to decline the LFP rate starts to increase after about half a year. Using gross flow data on labor market transitions, we show that this cyclical co-movement pattern between the unemployment rate and the LFP rate can be attributed to two factors. First, low unemployment rates imply a low average exit rate from the labor force, which in turn increases the LFP rate. Second, transition rates from out-of-the-labor-force to employment without an intervening unemployment spell increase as unemployment rates decline. A third reason that is commonly mentioned as a source for the negative co-movement between unemployment and LFP cannot be con firmed. According to this reasoning, unemployed workers are less likely to exit the labor force and inactive participants are more likely to join the labor force as unemployed when unemployment declines. In fact, the data suggest that the opposite is true. The behavior of unemployment and LFP in the current recovery has been 'unusual' even though the unemployment rate has been declining since 2010, the LFP rate has not yet begun to increase. This unusual behavior is potentially informative about the relative magnitude of the cyclical and trend component in recent LFP rate movements