This research asks: Under what conditions might this concern, that temporary shocks might be propagated through a persistent reduction in consumption demand, be justified?

The group (consisting of Tobias Broer, IIES, PSE and CEPR, Jeppe Druedahl, University of Copenhagen and CEBI, Karl Harmenberg, Copenhagen Business School, and Erik Öberg, Uppsala University and UCLS) shows how the structure of labor markets is key for the consumption response to temporary shocks. When job creation is costless, as in standard models of the labor market, a temporary fall in productivity has no long-term consequences, as firms hire their workers back quickly after the shock subsides. When there is hysteresis in hiring, in contrast, for example because some jobs are lost and need to be recreated by paying an upfront start-up cost, the increase in the number of unemployed through increased firing and slow vacancy creation lead to a fall in the job-finding rate that lasts substantially longer than the shock itself. This strongly increases precautionary savings and reduces aggregate demand, which amplifies the original fall in output and propagates it for a long time after the shock has subsided. They show how versions of the model where some of its elements (sticky prices, no market for private insurance, sluggish hiring because of fixed costs of creating vacancies, and a direct effect of the shock on job separations) are absent do not predict such propagation. Finally, they show how match-saving subsidies like those enacted by some countries can effectively stabilize output in response to a temporary shock.

Contact at IIES: Tobias Broer.

Click here to read the paper in full.