Frictional Unemployment with Stochastic Bubbles

Financial markets and labor markets are linked: aggregate employment and stock market indices co-move positively and their volatility is comparable. While existing search-and-matching models perfectly capture the relative magnitude of these volatilities (Pissarides' law), they fail in predicting their level (Shimer puzzle). We show that bubbles in a search-and-matching economy allow amplifying volatility in firm value and replicating the empirical volatility of unemployment. Firms switch randomly between a stationary state and a bubbly state in which firm value is explosive. The coordination on explosive solutions induces distortions in hiring decisions and wages, which we explicitly characterize. The specification significantly improves the quantitative ability of the model to match US data, along both real and financial dimensions