Imperfect Information, Lagged Labor Adjustment and the Great Moderation

This paper first documents the increase in the time lag with which labor input reacts to the economy's driving structural shocks ("the labor adjustment lag") that is visible in US data since the mid-1980s. We show that lagged labor adjustment is optimal in a setting where there is uncertainty about the persistence of shocks and where labor input is costly to adjust. We then present evidence that both the nature of shocks hitting the economy as well as labor adjustment costs have changed since the 1980s in a direction that could explain the increase in the lag. Finally, we argue that the increase in the labor adjustment lag has the potential to explain some macroeconomic puzzles that characterize post-1984 US data, such as the reduced procyclicality of labor productivity and the reduction in output volatility (known as the Great Moderation)