Endogenous separation, wage rigidity and the dynamics of unemployment

Previous attempts to evaluate the Mortensen–Pissarides model rely on either endogenous separation or wage rigidity. In this paper I simulate a version of the Mortensen–Pissarides (MP) model with wage rigidity and endogenous separation. The model is then able to answer a key question in the literature: can wage rigidity and endogenous separation explain the joint dynamics of unemployment, vacancies and wages? I find that it can. The model generates sufficient volatility in unemployment, the separation rate and the finding rate, 75% of the observed volatility in vacancies, and 70% of the Beveridge curve (the negative correlation between unemployment and vacancies). More substantially, the model matches the volatility of the average wage and generates a response of new hires’ wages to productivity and unemployment consistent with key estimates in the literature. I then simulate the model while restricting the separation rate to be constant and show that the model predicts only 70% of the variance of unemployment. I conclude that finding rate fluctuations explain 70% of unemployment fluctuations halfway in between the most prominent estimates in the literature.