Sectoral Shocks and Movement Costs: Effects on Employment and Welfare

Abstract

**Below is a description of the paper and not the actual abstract.**We set up a general equilibrium model of a two-sector economy in which movement costs across sectors play a crucial role in explaining the cyclical fluctuations of employment, even though there is little labor reallocation across sectors as it responds to sectoral shocks. This model serves to reconcile the seemingly contradictory results of recent macro and micro studies; namely that macro evidence favors for sectoral shocks to explain fluctuations of employment, even though micro studies show little evidence of cyclical movements of labor across sectors. The model also has the property that, holding the magnitude of the shocks fixed, increasing their frequency decreases total employment since labor reallocation is less complete as agents expect more volatile shocks. Given that sectoral shocks have been more frequent in the post-1970 era, the implications of the model are consistent with the well documented evidence that the unemployment rate itself is higher in the post-1970 era than in the previous decades. We also study the theoretical implications of two possible policies to increase total employment. While the first one, which is to increase mobility by subsidizing movers, increases both total employment and social welfare, the second one, which is to eliminate the partial insurance provided in the model, increases total employment but at a loss in welfare.

JEL Classification: E13, E32, E60, J62