Macroeconomics II: Search and Matching

Part 1

Luiz Brotherhood

Universitat de Barcelona

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A primer on recursive economics

A simple model:
• Time is discrete and infinite: t = 0, 1, . . .
• Linear utility: utility(x ) = x .
• Agent’s discount factor: β.
• If unemployed consumes b > 0.
• If employed consumes w > b.
• Probability of getting a job is p ∈ (0, 1).
• Once worker gets a job, she decides never to leave it (why?).

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A primer on recursive economics

• First suppose that the worker starts employed.

• Discounted lifetime utility (“value”) of a worker employed:

E = w + βw + β 2 w + . . .
 
E = w + β w + βw + β 2 w + . . .
| {z }
=E
E = w + βE

• The last equation is a simple example of “recursive economics”.

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A primer on recursive economics

• If worker is unemployed:

U t=0
p 1−p
E U t=1
p 1−p
E U t=2
p 1−p

E ... t=3

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A primer on recursive economics

• Expected utility of being unemployed:

 

 

U =b+β pE + (1 − p)[b + β {pE + (1 − p) [b + β {. . . }]}]

 | {z }

=U
= b + β {pE + (1 − p)U}

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A primer on recursive economics

• Suppose that, if the worker is employed, she goes to unemployment

with probability s ∈ (0, 1).

E = w + β {sU + (1 − s)E }
U = b + β {pE + (1 − p)U}

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A primer on recursive economics
• The previous model is stationary: environment doesn’t change over
time.
• b, w , p and s don’t change over time.
• What if environment is non-stationary?
• Suppose that wages follow a sequence over time, {wt }∞ t=0 .
• Worker knows the full path of wages.
• Now we can have wt < b for some t.
• It may be optimal for the worker to leave job or reject job offer at some
point.

Et = wt + β {sUt+1 + (1 − s) max{Et+1 , Ut+1 }}

Ut = b + β {p max{Et+1 , Ut+1 } + (1 − p)Ut+1 }

• Will the worker always reject a job with wt < b?

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Baseline model

• Continuum of identical workers with measure normalized to one.

• Workers are infinitely lived and risk neutral: utility(x ) = x .
• Objective of worker: maximize discounted utility.
• Leisure enjoyed by the worker (or unemployment insurance, or home
production): b > 0.
• Labor income: wage w > 0.
• Worker’s discount factor: β.

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Baseline model

• Each firm employs at most one worker (one-to-one match).

• Firm entry cost: c.
• Firm’s per-period earnings: y − w .
• All matches are exogenously destroyed with probability s.
• Firms have the same discount as the workers.

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Matching function

• Search frictions:
• Firms look for workers and workers look for firms.
• Some of them don’t find each other.
• u: mass of unemployed workers looking for a job.
• v : mass of firms looking for a worker (vacancies posted).
• m(u, v ): [matching function] mass of workers and firms that find each
other.

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Matching function
Matching function properties:
• Increasing in both u and v :

mi (u, v ) > 0, i = 1, 2.

Generates thin market externalities: the greater the number of

unemployed workers (vacancies) the easier is for the firm (worker) to
find a worker (job).
• The marginal contribution of u and v to the aggregate number of
matches is decreasing:

mii (u, v ) < 0, i = 1, 2.

Generates congestion externalities: the greater the number of firms

(workers) searching, the more difficult is to find a worker (job).

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Matching function

• The matching function has constant returns to scale:

m(λu, λv ) = λm(u, v ) for all λ > 0.

The relative “size” of the labor market doesn’t matter.

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Matching function
• Define the market tightness as:
v
θ≡ .
u
• All workers looking for jobs are in the same labor market and have the
same probability of being found by a firm. Therefore, the probability of
a worker finding a job is

m(u, v ) v
 
= m 1, = m(1, θ) ≡ p(θ).
u u
• Similarly, the probability of a firm finding a worker is

m(u, v ) u
 
=m , 1 = m(θ−1 , 1) ≡ q(θ).
v v
• Given properties of matching function, p 0 (θ) > 0, q 0 (θ) < 0 and
θq(θ) = p(θ). Why?
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Matching function

Examples of matching functions used in the literature:

• Cobb-Douglas:
m(u, v ) = Au α v 1−α .
• Den Haan, Ramey, and Watson (AER, 2000):

u·v
m(u, v ) = 1/l
.
(u l + v l )

• How are p(θ) and q(θ) for the two matching functions above?

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Baseline model
Timing of the model:
Production stage
t • (1 − ut ) firms get y − wt
• (1 − ut ) workers get wt
• ut workers get b
• vt firms pay c
• values measured in this stage
• vt determined
• wt determined
Matching stage
• ut pt workers get jobs t +1
• vt qt firms fill vacancies
• (1 − ut )s workers lose jobs
• (1 − ut )s firms lose workers
• ut+1 determined
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Baseline model

• In each period there are employed and unemployed workers.

• The evolution of the mass of unemployed workers over time is

ut+1 = ut [1 − p(θt )] + (1 − ut )s.

• Let’s start by analyzing the steady state, which is the situation in

which ut+1 = ut :
s
ut+1 = ut = u =⇒ u = ,
s + p(θt )

implying that θt is fixed in the steady state, θ.

• Later we study the convergence of the economy to the steady state.

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Baseline model

• Worker’s value of being employed:

E = w + β [sU + (1 − s)E ] . (1)

• Worker’s value of being unemployed:

U = b + β {p(θ)E + [1 − p(θ)] U} . (2)

• Firm’s value of having a worker employed:

J = y − w + β [sV + (1 − s)J] . (3)

• Firm’s value of looking for a worker (posting a vacancy):

V = −c + β {q(θ)J + [1 − q(θ)] V } . (4)

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Baseline model

• Firms enter in the market until all profitable opportunities are

exhausted:
V = 0.
Implies that:
c
J= . (5)
βq(θ)
• Last equation to close the model is a condition to determine wages.

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Nash bargaining

• When a worker and a firm meet they generate surplus: the value
obtained by each party inside the relation is bigger than the value that
the party obtains outside the relation.

Worker’s surplus: E − U

Firm’s surplus: J − V
Total surplus: S ≡ (E − U) + (J − V )

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Nash bargaining

• Worker and firm meets and bargain over surplus of the match.
Intuition?
• Bargain is such that surplus of the worker and firm maximize a
weighted average of surpluses:
max (E − U)φ (J − V )1−φ
E −U,J−V >0

subject to S = (E − U) + (J − V ).

• Solution to problem is:

E − U = φS and J − V = (1 − φ)S.

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Solving the model

• What are the equilibrium variables and endogenous/exogenous

variables?
• Let’s go to the board and find:
• Free-entry equation (demand for labor):

r +s
w =y− c.
q(θ)

• Wage equation (labor supply):

w = b + φ(y − b + θc).

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Beveridge curve

• Beveridge curve:

s v
 
B = (u, v ) ∈ R2 : u = , θ=
s + p(θ) u

v
 
Θ = θ ∈ R : (u, v ) ∈ B, θ =
u
∂u ∂v
< 0, >0
∂θ ∂θ
• Use p(θ) = θq(θ).
• Why is each (u, v ) ∈ B associated to a different θ?

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Equilibrium

r +s
Wage curve: w = y − c
q(θ)

Job creation: w = φy +(1−φ)b+φcθ

s
Beveridge curve: u =
s + p(θ)

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Comparative statics

• The following equations can be used to study comparative statics in

the model:
c [r + s + φp(θ)]
(y − b) =
(1 − φ)q(θ)
s
u=
s + p(θ)
v
θ=
u

w = φy + (1 − φ)b + φcθ
r +s
w =y− c
q(θ)

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Transition

• What if the economy is not in the steady state?

• We may have that ut+1 6= ut .
• Now all equilibrium variables (ut , vt , wt ) may vary across time.
• Two interpretations of transition to steady state:
• Initial conditions different from steady state.
• Unexpected change in parameter(s) value(s) (governmental policy,
international shock, ...).

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Transition

• Now values may depend on time:

Et = wt + β [sUt+1 + (1 − s)Et+1 ]

Ut = b + β {p(θt )Et+1 + [1 − p(θt )] Ut+1 }

Jt = y − wt + β [sVt+1 + (1 − s)Jt+1 ]

Vt = −c + β {q(θt )Jt+1 + [1 − q(θt )] Vt+1 }

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Transition

• We still have free-entry and Nash bargaining conditions:

Vt = 0 for all t ≥ 0

Et − Ut = φSt

Jt = (1 − φ)St

St ≡ Et − Ut + Jt

• Let’s characterize St . Why?

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Transition

Et − Ut = wt − b + β {sUt+1 + (1 − s)Et+1
−p(θt )Et+1 − [1 − p(θt )] Ut+1 }
= wt − b + β {s (Ut+1 − Et+1 )
+p(θt ) (Ut+1 − Et+1 ) − (Ut+1 − Et+1 )}
= wt − b + β (Ut+1 − Et+1 ) {s + p(θt ) − 1}
= wt − b + β (Et+1 − Ut+1 ) {1 − s − p(θt )}

φSt = wt − b + βφSt+1 [(1 − s) − p(θt )]

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Transition

Jt = y − wt + β(1 − s)Jt+1

(1 − φ)St = y − wt + β(1 − s)(1 − φ)St+1

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Transition

St = φSt + (1 − φ)St
= wt − b + βφSt+1 [1 − s − θt q(θt )]
+ y − wt + β(1 − s)(1 − φ)St+1
= y − b + βSt+1 {φ(1 − s) − φp(θt ) + (1 − φ)(1 − s)}
= y − b + βSt+1 {(1 − s) − φp(θt )}

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Transition

c
Vt = 0 =⇒ St+1 =
β(1 − φ)q(θt )

St+1 = y − b + βSt+2 {(1 − s) − φp(θt+1 )}

c c
=y −b+β {(1 − s) − φθt+1 q(θt+1 )}
β(1 − φ)q(θt ) β(1 − φ)q(θt+1 )

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Transition

• Using the Cobb-Douglas matching function:

c c n
1−α
o
= y − b + β (1 − s) − φAθ
β(1 − φ)Aθt−α −α
β(1 − φ)Aθt+1 t+1

(y − b)(1 − φ)Aβ
θtα = α
+ (1 − s)βθt+1 − φAβθt+1
c

• Defining xt ≡ θ α ,

(y − b)(1 − φ)Aβ 1/α

xt = + (1 − s)βxt+1 − φAβxt+1 .
c

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 45-degree line

xt = f (xt+1 )

• xt = f (xt+1 ) = (y −b)(1−φ)Aβ
1/α
c + (1 − s)βxt+1 − φAβxt+1
• To think about the blue curve’s format more clearly, suppose that
α = 1/2. In this case, the right-hand side becomes a polynomial of
degree two.
• How does the format change when α 6= 1/2?

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 xt = f (xt+1 )
xt

xt+1

• The blue curve says that, if we have xt+1 at some point in time, then
it must be preceded by xt .

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 xt = f (xt+1 )
xt

1 2
xt+1 xt+1

• If we have xt at some point in time, at first we don’t know whether

1
the next point is xt+1 2 .
or xt+1
• However, we can discard some values of xt .

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 xty

xt = f (xt+1 )

• We cannot have xt = xty at some point in time, because there is no

xt+1 that satisfies xty = f (xt+1 ), and equation xt = f (xt+1 ) must hold
for all points in the sequence {xt }∞ t=1 .

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 y
xt+1

xty

xt = f (xt+1 )

x
xt+1

• Now suppose we have xt = xty for some t.

x .
• One value that satisfies the equation is xt+1 = xt+1
y
• If we project xt+1 to the y axis, we have xt+1 .
• But we cannot have this value (previous slide).
x .
• Therefore, the next value of the sequence cannot be xt+1 = xt+1

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 xty

xt = f (xt+1 )

x
xt+1

x
• But we cannot have xt+1 = xt+1 neither.
• Therefore, we cannot have xt = xty at some t > 0.

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 L

xt = f (xt+1 )

• The previous reasoning works for any L < xt ≤ L.

• Now let’s see a 0 ≤ xt < L.

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 xty xt = f (xt+1 )
y
xt+1
y
xt+2
y
xt+3
x x
xt+3 xt+1
x
xt+2

• Suppose xt = xty for some t > 0.

x .
• Then we must have xt+1 = xt+1
y
• Projecting xt+1 to the y axis, we have xt+1 .
y
• If we keep doing this, we reach the point xt+3 , which is impossible.
• Therefore, we cannot have 0 ≤ xt < L.
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 xty

xt = f (xt+1 )

x
xt+1

• The only value left for xt is xty , which implies that xt+1 = xt+1
x .

• But then xt = xt+1 , implying that xty = xt+1x is the steady state value
of the sequence {xt }∞
t=1 .

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Transition

• Market tightness jumps to the steady state value.

• But ut and vt do not.

ut+1 = ut [1 − p(θ)] + (1 − ut )s

θ
vt =
ut

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 xt = f (xt+1 )

• What about the case in which the lines cross after the peak of the blue
curve?
• Let’s go to Matlab.

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Efficiency

• Social planner’s problem.

• Chooses vacancies and number of employed workers in each period.
• Subject to search frictions.
• To maximize discounted value of output and leisure net of vacancy
costs.
∞
X
max β t [ynt + b(1 − nt ) − cvt ]
{vt ,nt+1 }∞
t=0 t=0

vt
 
subject to nt+1 = (1 − s)nt + q vt
1 − nt
n0 given.

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Efficiency

• First order conditions are:

−β t c + λt q 0 (θt )θt + q(θt ) = 0

 

h i
−λt + β t+1 (y − b) + λt+1 (1 − s) + q 0 (θt+1 )θt+1
2
=0
• Can be arranged into:

c βc h
0 2
i
= β(y − b) + (1 − s) + q (θ t+1 )θ t+1
p 0 (θt ) p 0 (θt+1 )

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Efficiency

• Using Cobb-Douglas matching function:

c βc
= β(y − b) + [(1 − s) − αq(θt+1 )θt+1 ]
(1 − α)q(θt ) (1 − α)q(θt+1 )
• Decentralized equilibrium is only efficient if α = φ.
• In steady state:
c [r + s + αp(θ)]
y −b =
(1 − α)q(θ)
• If α is high (α > φ), an additional vacancy has a large negative impact
on all firms’ probability of filling a vacancy (q(θ) = Aθ−α ); the social
the social planner would therefore like to reduce the number of
vacancies by granting workers a relatively high bargaining power

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