Did the Natural Rate of Unemployment Rise? 7

namesake (Beveridge 1944) and formalized in subsequent research, the Beveridge namesake (Beveridge 1944) and formalized in subsequent research, the Beveridge curve is essentially a production possibility frontier for the job matching capabilities curve is essentially a production possibility frontier for the job matching capabilities of the labor market, where the rate at which job seekers are matched to job openings of the labor market, where the rate at which job seekers are matched to job openings depends primarily on the ratio of the vacancy rate to the unemployment rate (Dow depends primarily on the ratio of the vacancy rate to the unemployment rate (Dow and Dicks-Mireaux 1958; Blanchard and Diamond 1989; Petrongolo and Pissarides and Dicks-Mireaux 1958; Blanchard and Diamond 1989; Petrongolo and Pissarides 2001). The job vacancy rate is constructed (analogous to the unemployment rate) as a 2001). The job vacancy rate is constructed (analogous to the unemployment rate) as a ratio of the number of vacancies to the sum of the total employed plus the number of ratio of the number of vacancies to the sum of the total employed plus the number of vacancies. It measures the incidence of open but unfi lled jobs in the economy. Move-vacancies. It measures the incidence of open but unfi lled jobs in the economy. Move- ment along the BC refl ects cyclical changes in aggregate labor demand: for example, ment along the BC refl ects cyclical changes in aggregate labor demand: for example, as labor demand weakens, vacancies decline and the unemployment rate rises, causing as labor demand weakens, vacancies decline and the unemployment rate rises, causing movement towards the lower right in the diagram. By contrast, an outward shift in movement towards the lower right in the diagram. By contrast, an outward shift in the overall position of the BC refl ects a decline in the effi ciency of the job matching the overall position of the BC refl ects a decline in the effi ciency of the job matching process: for a given level of vacancies, workers have more trouble fi nding acceptable process: for a given level of vacancies, workers have more trouble fi nding acceptable jobs, and for a given level of unemployment, fi rms have more trouble fi nding suit-jobs, and for a given level of unemployment, fi rms have more trouble fi nding suit- able workers.able workers.33 All else equal, reduced matching effi ciency will raise the frictional or All else equal, reduced matching effi ciency will raise the frictional or structural level of unemployment, hence the natural rate of unemployment.structural level of unemployment, hence the natural rate of unemployment.

As Figure 1 shows, the Beveridge curve by itself does not determine an equilibrium As Figure 1 shows, the Beveridge curve by itself does not determine an equilibrium combination of vacancies and unemployment. This requires the job creation curve, combination of vacancies and unemployment. This requires the job creation curve, which is determined by fi rms’ recruiting behavior. Firms hire workers to produce which is determined by fi rms’ recruiting behavior. Firms hire workers to produce output and will create vacancies up to the point where the expected value of a job output and will create vacancies up to the point where the expected value of a job match equals the expected search cost to fi ll the vacancy. The expected value of a match equals the expected search cost to fi ll the vacancy. The expected value of a job match is determined by the marginal product of labor. The expected search cost job match is determined by the marginal product of labor. The expected search cost combines fi rms’ direct recruiting expenses with the probability that a job is fi lled.combines fi rms’ direct recruiting expenses with the probability that a job is fi lled.

In the basic model we discuss here, the probability of fi lling a job rises with In the basic model we discuss here, the probability of fi lling a job rises with the unemployment rate. Thus, the job creation curve is upward sloping, implying the unemployment rate. Thus, the job creation curve is upward sloping, implying that fi rms create more job openings when unemployment is higher (as depicted in that fi rms create more job openings when unemployment is higher (as depicted in Figure 1). The exact degree of upward slope is affected by other factors that may Figure 1). The exact degree of upward slope is affected by other factors that may change over time or across the business cycle, such as the job separation rate, the change over time or across the business cycle, such as the job separation rate, the level of recruiting costs, and the value of jobs (as refl ected in worker productivity level of recruiting costs, and the value of jobs (as refl ected in worker productivity and the value of output). More generally, the slope of the JCC depends on the and the value of output). More generally, the slope of the JCC depends on the structure of the product and labor markets in which fi rms operate and how they structure of the product and labor markets in which fi rms operate and how they bargain over wages, as well as external factors such as the discount or interest rate.bargain over wages, as well as external factors such as the discount or interest rate.

Changes in the expected value of a job associated with changes in the marginal Changes in the expected value of a job associated with changes in the marginal product of labor can shift the job creation curve (as depicted in Figure 1). This product of labor can shift the job creation curve (as depicted in Figure 1). This is a channel through which shifts in aggregate demand can affect the unemploy-is a channel through which shifts in aggregate demand can affect the unemploy- ment rate even when the effi ciency of the job matching process is unchanged. For ment rate even when the effi ciency of the job matching process is unchanged. For example, in recessions, declines in aggregate demand reduce the marginal product example, in recessions, declines in aggregate demand reduce the marginal product of labor, which reduces the value of creating jobs. This causes the JCC to rotate of labor, which reduces the value of creating jobs. This causes the JCC to rotate

3 Petrongolo and Pissarides (2001) describe the derivation of the Beveridge curve from an underlying job matching technology and discuss functional forms for the job matching function. The BC is typically depicted as convex to the origin, which is consistent with job matching functions that have constant returns to scale in unemployment and vacancies (and hence diminishing returns to either factor with the other one fi xed).

8 Journal of Economic Perspectives

down, resulting in a higher unemployment rate with no shift in the Beveridge curve. down, resulting in a higher unemployment rate with no shift in the Beveridge curve. Although this decline in aggregate demand increases measured unemployment, Although this decline in aggregate demand increases measured unemployment, it does not raise the natural rate of unemployment. Theoretically, the JCC can it does not raise the natural rate of unemployment. Theoretically, the JCC can also shift in response to changes in fi rm search costs. If the probability of fi lling a also shift in response to changes in fi rm search costs. If the probability of fi lling a vacancy falls, for example due to a rise in skill mismatch, the JCC will rotate down, vacancy falls, for example due to a rise in skill mismatch, the JCC will rotate down, indicating a lower rate of vacancies posted for a given job value.indicating a lower rate of vacancies posted for a given job value.

The key implication of this model is that the equilibrium unemployment rate is The key implication of this model is that the equilibrium unemployment rate is determined jointly by the intersection of the Beveridge curve and the job creation determined jointly by the intersection of the Beveridge curve and the job creation curve. In this framework, changes in the equilibrium unemployment rate, point curve. In this framework, changes in the equilibrium unemployment rate, point a in in Figur e 1, can occur due to an outward shift in the BC, a downward shift in the JCC, Figur e 1, can occur due to an outward shift in the BC, a downward shift in the JCC, or a combination of both. The example in Figu re 1 illustrates how shifts in these or a combination of both. The example in Figu re 1 illustrates how shifts in these curves can affect equilibrium unemployment. In the illustration, an outward shift in curves can affect equilibrium unemployment. In the illustration, an outward shift in the BC from BC to BCthe BC from BC to BC′′ shifts equilibrium unemployment from shifts equilibrium unemployment from a to to b. Since the JCC . Since the JCC is upward sloping, equilibrium unemployment increases by less than the outward is upward sloping, equilibrium unemployment increases by less than the outward shift in the BC. In this model, the unemployment rate can only increase by the same shift in the BC. In this model, the unemployment rate can only increase by the same amount as the rightward shift in the BC if the JCC is fl at or shifts outward (or down) amount as the rightward shift in the BC if the JCC is fl at or shifts outward (or down) as in JCas in JC′′. In these cases, equilibrium unemployment would move from . In these cases, equilibrium unemployment would move from b to to c..

One main message from this graphical illustration is that knowledge of the One main message from this graphical illustration is that knowledge of the Beveridge curve is not suffi cient to draw conclusions about equilibrium unemploy-Beveridge curve is not suffi cient to draw conclusions about equilibrium unemploy- ment. As the fi gure shows, it is not possible to infer, for a given shift in the BC, ment. As the fi gure shows, it is not possible to infer, for a given shift in the BC, how much the unemployment rate changes without knowing the shape of the job how much the unemployment rate changes without knowing the shape of the job creation curve. This point may seem obvious, but it has been overlooked in policy creation curve. This point may seem obvious, but it has been overlooked in policy discussions in which shifts in the BC are interpreted as one-for-one increases in the discussions in which shifts in the BC are interpreted as one-for-one increases in the natural rate of unemployment.natural rate of unemployment.

The insights from this model of equilibrium frictional unemployment point The insights from this model of equilibrium frictional unemployment point to two directions for empirical analysis. First, to understand the driving forces of to two directions for empirical analysis. First, to understand the driving forces of the rise in the unemployment rate, one must consider not only what is shifting the rise in the unemployment rate, one must consider not only what is shifting the Beveridge curve and by how much, but also what is affecting fi rms’ incentives the Beveridge curve and by how much, but also what is affecting fi rms’ incentives for job creation. Second, to distinguish what part of the rise in the unemployment for job creation. Second, to distinguish what part of the rise in the unemployment rate refl ects purely cyclical fl uctuations in labor demand and what parts are due to rate refl ects purely cyclical fl uctuations in labor demand and what parts are due to other factors, either transitory or permanent, that raise the natural rate, one has other factors, either transitory or permanent, that raise the natural rate, one has to consider what is driving the shifts in the BC and the JCC and how long these to consider what is driving the shifts in the BC and the JCC and how long these effects are likely to last. We consider these in turn.effects are likely to last. We consider these in turn.