Coordination and the Dynamics of Unemployment

We introduce a standard aggregate demand externality into the Mortensen-Pissarides benchmark model of equilibrium unemployment. Because firms worry about the demand for their products, an increase in unemployment lowers the incentives to post vacancies which further increase unemployment. This positive feedback creates a coordination problem among firms and naturally leads to multiple equilibria. To handle this indeterminacy, we show that the economy features a unique equilibrium for a small departure from common knowledge. The unique equilibrium exhibits interesting dynamic properties. In particular, the influence of the mechanism on the economy grows with the size and duration of shocks, such that multiple stationary points in the dynamics of unemployment can exist. We calibrate the model to the U.S. economy and show that the aggregate demand channel generates substantial additional volatility and persistence in labor market variables. In particular, the model generates deep, long-lasting recessions. We document features of the U.S. dataWe should do the VAR exercise we did in uncertainty traps. that are consistent with the unusual dynamic properties of the model.