Uncertainty and Unemployment

This paper studies the impact of time‐varying idiosyncratic risk at the establishment level on unemployment fluctuations over 1972–2009. I build a tractable directed search model with firm dynamics and time‐varying idiosyncratic volatility. The model allows for endogenous separations, entry and exit, and job‐to‐job transitions. I show that the model can replicate salient features of the microeconomic behavior of firms and that the introduction of volatility improves the fit of the model for standard business cycle moments. In a series of counterfactual experiments, I show that time‐varying risk is important to account for the magnitude of fluctuations in aggregate unemployment for past U.S. recessions. Though the model can account for about 40% of the total increase in unemployment for the 2007–2009 recession, uncertainty alone is not sufficient to explain the magnitude and persistence of unemployment during that episode.