Working Papers Federal Reserve Bank of Philadelphia
Using a representative-household search and matching model with endogenous labor force participation, we study the cyclicality of labor market transition rates between employment, unemployment, and nonparticipation. When interpreted through the lens of the model, the behavior of transition rates implies that the participation margin is strongly countercyclical: the household’s incentive to send more workers to the labor force falls in expansions. We identify two key channels through which the model delivers this result: (i) the procyclical values of non-market activities and (ii) wage rigidity. The smaller the value of the extensive-margin labor supply elasticity is, the stronger the first channel is. Wage rigidity helps because it mitigates increases in the return to market work during expansions. Our estimated model replicates remarkably well the behavior of transition rates between the three labor market states and thus the stocks, once these two features are in place.