Responding to the Shimer Puzzle

A large number of economists have recently proposed new versions of the Mortensen-Pissarides model designed to address the model's difficulty in matching the high variance of unemployment that we observe in the data (the so-called Shimer puzzle). Some of the proposed solutions are based on wage rigidity. If wage changes in response to shocks are dampened, the model does a better job at matching the data. But research CEP macro program member Chris Pissarides points out that what matter for the theory is the flexibility of new wages (i.e. of wages of newly employed workers) and that, in the data, new wages are actually very flexible. This means that any resolution to the puzzle should rely on wage rigidity.

Meanwhile, CEP macro program member Régis Barnichon argues that the Shimer puzzle is not as serious as usually thought. He argues that part of the problem lies in the incorrect identification of productivity shocks. In particular Shimer overstates the role of productivity shocks by failing to recognize that much of observed variation in productivity is an endogenous response to demand shocks. Using a New- Keynesian framework with search unemployment, he estimates that close to 50 per cent of the Shimer puzzle is due to the misidentification of productivity shocks. In addition, he shows that extending the search model with an aggregate demand side remarkably improves the ability of the standard search model to match the moments of key labour market variables.

To read more about the Shimer puzzle see:

• "The Unemployment Volatility Puzzle: Is Wage Stickiness the Answer?" [Full document in Adobe PDF] (Chris Pissarides), CEP Discussion Paper 0839, November 2007
  
  
• "The Shimer Puzzle and the Correct Identification of Productivity Shocks" [Full document in Adobe PDF] (Régis Barnichon), CEP Discussion Paper 0823, August 2007