A Mechanism of Cyclical Volatility in the Vacancy-Unemployment Ratio: What Is the Source of Rigidity?

The conventional search and matching model has been criticized for its inability to explain large cyclical volatility in the vacancy-unemployment ratio without ad hoc assumptions of wage rigidity. This paper presents a mechanism of such volatility without assuming wage rigidity by showing that households can rationally select a Nash equilibrium consisting of strategies of choosing a Pareto inefficient transition path. This type of path is generated after a time preference shock and causes a persistently large amount of extra unutilized resources. The labor market is thereby distorted and becomes more cyclically volatile. Vacancy costs are particularly affected by this Nash equilibrium. Because this Pareto inefficient path proceeds “rigidly,” that is, the Pareto inefficiency diminishes gradually, an ingredient of rigidity is introduced into the economy, and the vacancy-unemployment ratio experiences large cyclical fluctuations.