The Foundation of Modern Macroeconomics more long-term unemployed, so that even if the original long-term unemployed have died (or found a job), the thinness of

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The Foundation of Modern Macroeconomics more long-term unemployed, so that even if the original long-term unemployed have died (or found a job), the thinness of the labour market remains. A temporary shock is self-perpetuating.

9.3 Punchlines In this chapter we discuss the flow approach to the labour market. This is by far the most technically demanding theory of the labour market discussed in this book because it abandons the notion of an aggregate labour market altogether and instead directly models the flows of labour that occur in the economy, namely the movements of workers from unemployment into jobs and vice versa.

Because the theory is inherently quite demanding, we only present the simplest possible search model. The central elements in the model are the following. First, there are frictions in the process by which job-seeking unemployed workers come into contact with firms that are looking for a worker to fill a vacancy. These frictions are costly and time consuming. Second, the crucial analytical device that makes the model tractable is the so-called matching function. (This function plays a similar role in the flow approach to the labour market that the neoclassical production function plays in the theory of factor productivity and growth.) The matching function relates the probabilities of workers meeting firms (and firms meeting workers) as a function of an aggregate labour market tightness variable. This tightness indicator is the ratio of vacancies and unemployed workers.

If the vacancy-unemployment ratio is high (low) then the probability that an unemployed job seeker finds a firm with a vacancy is high (low) and expected duration of the search for a job is low (high). The matching function also explains the conditions facing the other party on the market. Indeed, if the vacancyunemployment ratio is high (low), then there are many (few) firms trying to locate an unemployed worker so that the probability that an individual firm is successful is low (high) and the expected duration of the firm's search process is high (low).

The third key ingredient of the search model concerns the wage formation process.

Once a firm with a vacancy meets an unemployed worker a pure economic rent is created consisting of the sum of foregone expected search costs by the firm and the worker. This surplus must be divided somehow between the firm and the worker. The typical assumption in this literature is that the two parties bargain over the wage.

The fourth ingredient of the model is the so-called Beveridge curve which relates the equilibrium unemployment rate to the (exogenous) job destruction rate (regulating the flow into unemployment) and the workers' job finding rate (regulating the flow out of unemployment).