Labor-Market Hysteresis and Persistent Paradox-of-Thrift Recessions

• Department of Economics

In this seminar Jeppe Druedahl, University of Copenhagen (CEBI) , presents the paper "Labor-Market Hysteresis and Persistent Paradox-of-Thrift Recessions".

Following the recent disruption in production due to COVID-19, we investigate whether temporary adverse shocks can result in persistent demand-driven recessions through sluggish labor-market dynamics.

We consider an incomplete-markets model with sticky prices and search frictions, and show how introducing sluggish vacancy creation and endogenous layoffs gives rise to a powerful and persistent feedback loop between unemployment risk and aggregate demand. Endogenous layoffs are central because they generate a rapid rise in unemployment following a temporary shock. Sluggish vacancy creation is central because it implies that job-finding rates remain persistently low following the surge in layoffs. As a result, the negative feedback loop continues even after the initial shock dies out. The feedback mechanism is weak in the corner cases of either free entry, exogenous separations or complete markets. The model provides justification for using match-saving subsidies to stabilize the business cycle.