The Consumption-Tightness Puzzle

This chapter introduces a labor force participation choice into a labor market matching model embedded in a dynamic stochastic general equilibrium set-up with production and savings. The participation choice is modelled as a trade-off between foregoing the expected benefits of actively searching and engaging in a costly labor market search. The model introduces a symmetry in firms' and workers' search decision since both sides of the labor market vary search effort at the extensive margins. This set up is shown to be of considerable analytical convenience and gives rise to a linear relationship between labor market tightness and the marginal utility of consumption. We refer to the latter as the "consumption-tightness puzzle" because (1) it gives rise to a number of counterfactual implications, and (2) it is a robust implication of theory. Among the counterfactual implications are very low volatility of tightness, procyclical unemployment, and a positively sloped Beveridge curve. These implications all derive from procyclical variations in participation rates that follow from allowing for the extensive search margin.