Search Frictions and the Labor Wedge

IMF Working Papers, May 1, 2011

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Labor market search frictions do not explain fluctuations in the labor wedge per se.
Measuring the marginal rate of substitution (MRS) in terms of total hours artificially introduces procyclicality in the MRS.
When the MRS is correctly measured in terms of hours per worker, the labor wedge obtained is less variable than the one of the competitive model.
It is possible to measure a strongly procyclical labor wedge when the actual data generating process is a search model that allows for movements in both the extensive and intensive margins.

Distinction between extensive margin and intensive margin is crucial for correct measurement of the MRS.
Mis-measurement arises when total hours are used instead of hours per worker, leading to an artificial procyclicality in the MRS.
Comparative variability: labor wedge from correctly measured MRS (hours per worker) is less variable than the labor wedge implied by a competitive model.
A search model permitting movements in both margins can produce a strongly procyclical labor wedge in observed data.

Analysts should measure the MRS in terms of hours per worker rather than total hours to avoid introducing artificial procyclicality.
Empirical investigations of the labor wedge should account for both extensive and intensive margin movements to correctly interpret cyclicality.
Using prototype business cycle and search frameworks that incorporate margin movements is essential to reconcile measured wedges with underlying data-generating processes.