DP5670 | The Consumption-Tightness Puzzle

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02/05/2006

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Abstract

This paper introduces a labour force participation choice into a standard labour market matching model embedded in a dynamic stochastic general equilibrium set-up. The participation choice is modelled as a trade-off between forgoing the expected benefits of being search active and engaging in costly labour market search. In contrast to models with constant labour force participation, the model that we analyse induces a symmetry in firms' and workers' search decision since both sides of the labour market vary search effort at the extensive margins. We show that this set-up is (a) of considerable analytical convenience, and (b) that the introduction of a participation choice leads to a strong tendency for procyclical unemployment, very low volatility of labour market tightness, and for a positively sloped Beveridge curve. These implications are summarized by a linear relationship between the vu-ratio and the marginal utility of consumption that we refer to as the consumption-tightness puzzle given its counterfacutal implications. Moreover, we show that this relationship survives a number of extentions of the standard model and that it derives from the allowance for an endogeneous labour market participation choice.