Search-and-Matching Frictions and Labour Market Dynamics in Latvia

This paper examines, in an estimated, full-fledged New Keynesian DSGE model with Nash wage bargaining, sticky wage and high value of leisure akin to Christiano, Trabandt and Walentin (2011), whether search-and-matching frictions in the labour market can explain aggregate labour market dynamics in Latvia. If vacancies are not observed, the model can, to a reasonable degree, generate realistic variance and dynamics of unemployment and the correlation between unemployment and (latent) vacancies, yet at the expense of too volatile vacancies. As a by-product, one quarter ahead forecasts of hours worked and GDP exhibit less excess volatility and, thus, are more precise compared to a model without search-and-matching frictions. However, if both unemployment and vacancies are observed and a shock to matching efficiency is allowed for, then cyclical behaviour of forecasted vacancies as well as correlation between unemployment and vacancies tend to counter the data (to the advantage of a better fit of vacancy volatility), and the smoothed matching efficiency is counter-intuitively counter-cyclical. Hence the model cannot fit the three statistics – variance of unemployment and vacancies, and correlation between the two, simultaneously.