Monetary Shocks and Labor Market Equilibrium

This paper will investigate labor market equilibrium in a rational expectations model where unforeseen monetary shocks have real effects. On a less complex level than either paper, this paper attempts to investigate a job search model similar to that found in Lucas and Prescott [2] in the context of a rational expectations model similar to that originally investigated in Lucas [3]. The model developed generates an equilibrium pool of unemployed job searchers and hence what could be called a natural rate of unemployment due to the fact that there are firm specific demand shocks causing relative price fluctuations and inducing workers located in low demand markets to search out better employment alternatives and due to the fact that search is costly and hence the cost of increasing the probability a successful search to one is prohibitive. Unforeseen monetary shocks have an impact on the size of this pool of unemployed job searchers because they are in part confused with firm specific demand shocks. Rational expectations models having the characteristic that unforeseen monetary shocks can have real effects are by now quite familiar; however, no previous models have specifically analyzed a job search model in the context of a rational expectations model of the Lucas [3] variety. After construction of the model, the main focus of the paper will be to analyze the impact of changes in the variance of the aggregate monetary shock to which the economy is assumed subject upon the natural rate of unemployment. The paper is organized as follows. In Section II the basic model and behavioral assumptions are discussed. Equilibrium price and labor demand equations are derived in Sections III, IV, and V. In Section VI the conditions determining labor market equilibrium are derived and comparative statics analysis is investigated. Section VII summarizes the conclusions of the model.