Accounting for unemployment: the long and short of it

Shimer (2012) accounts for the volatility of unemployment based on a model of homogeneous unemployment. Using data on short-term unemployment he finds that most of unemployment volatility is accounted for by variations in the exit rate from unemployment. The assumption of homogeneous exit rates is inconsistent with the observed negative duration dependence of unemployment exit rates for the U.S. labor market. We construct a simple model of heterogeneous unemployment with short-term and long-term unemployed, and use data on the duration distribution of unemployment to account for entry to and exit from the unemployment pool. This alternative account continues to attribute most of unemployment volatility to variations in exit rates from unemployment, but it also suggests that most of unemployment volatility is due to the volatility of long-term unemployment rather than short-term unemployment. We also show that once one allows for heterogeneous unemployment, the expected value of income losses from unemployment increases substantially, and unemployment volatility implied by a simple matching model increases.