EC201 Macroeconomics 2, Spring 2016

University of Warwick
Thijs van Rens
Labour markets
Seminar questions - part II
In this exercise, you are asked to solve the search and matching model of the labor
market by yourself. This is the same model we discussed in the lecture and that is
described in chapter 1 of Pissarides (2000). By answering the questions one by one,
you will be guided towards the solution.
Workers can be unemployed or employed. An unemployed worker receives an
unemployment benet b and nds a job with ow probability p ( ) = 1 , where
0 < < 1, = v=u is aggregate labor market tightness, v are vacancies and u is the
fraction of workers that are unemployed. Employed workers receive a wage w > b but
with ow probability their job gets destroyed.
Firms create vacancies at a ow cost k. A vacancy nds a worker with probability
q ( ) = p ( ) = , in which case the vacancy turns into a lled job, which produces
output y and ends with ow probability . There is free entry of rms. Wages are set
by generalized Nash bargaining, where denotes workers bargaining power. Both
workers and rms discount future payos at rate r.
1. Write down the Bellman equations for an employed worker W , an unemployed
worker U , a lled job J and a vacancy V .
2. Write down two more equations that, together with the Bellman equations, fully
describe the equilibrium of this model in the endogenous variables W , U , J, V ,
and w.
3. Let S = W U + J V denote total match surplus and reduce the system of 6
equations in 6 endogenous variables into a system of 2 equations in the variables
and S.
4. Suppose the economy enters a recession, which we will think of as an unexpected,
permanent reduction in y. What happens to labor market tightness ?
5. Derive an expression for the wage in terms of S and . What happens to wages
in a recession?
6. Write down a law of motion for the unemployment rate in this model. Suppose
the unemployment rate is initially in steady state when the recession starts.
What happens to the unemployment rate in a recession?
7. Now suppose that there is an inow of immigrants into the labor market of the
previous question. Immigrants are identical to local workers and immediately
become part of the labor force. However, because they just arrived, initially all
immigrants are unemployed. Suppose that before immigration, the labor market
was in steady state. What happens to unemployment and wages in response
to immigration (in the short run and in the long run)? Explain the intuition
for this result. Are the above results consistent with your view of the eects
of immigration in the real world? If not, what aspects of the real world is the
model missing? (Hint: This is a conceptual question, you should not need a lot
of math to answer it!)