Loss of Skill and Labor Market Fluctuations

In this paper, we examine how skill loss can contribute to aggregate labor market fluctuations in the Diamond-Mortensen-Pissarides model. We develop a computationally tractable stochastic version of that model wherein workers accumulate skills on the job and face a risk of skill loss after job destruction. We find that skill heterogeneity dampens the fluctuations of labor market variables, and that introducing skill loss offsets this effect and generates additional amplification. The main forces driving this result are pro-cyclical increases in the probability of skill loss during unemployment: these provide incentives to post proportionally more vacancies during upturns by raising the surplus from employing high-skill workers. Compositional changes in the unemployment pool, on the other hand, play a negligible role for empirically plausible rates of skill depreciation, which imply a relatively slow process compared to the duration of unemployment spell.