Imperfect information, lagged labor adjustment and the Great Moderation

This paper first documents the increase in the time lag with which laborinput reacts to output fluctuations ("the labor adjustment lag") that is visi-ble in US data since the mid-1980s. We show that a lagged labor adjustmentresponse is optimal in a setting where there is uncertainty about the persis-tence of shocks and where labor input is costly to adjust. We then presentevidence that both the nature of shocks hitting the economy as well as laboradjustment costs may have changed during the 1980s in a direction that couldexplain the observed increase in the lag. Finally, we argue that the increasedlabor adjustment lag has the potential to explain some macroeconomic puz-zles that characterize post-1984 US data, such as the reduced procyclicality oflabor productivity and the reduction in output volatility (known as the GreatModeration).Key words: imperfect information, labor adjustment, jobless growth, optionvalue of waiting, Great ModerationJEL-classifications: E24, E32, J23, J24