Belief Shocks and Labor Market Dynamics

This paper studies the role of imperfect information in propagating labor market fluctuations, where agents are rational and form beliefs about the fundamentals of the economy by observing noisy signals about the aggregate state in a stylized search and matching framework. Noise shocks to beliefs affects the hiring decision of the firms as well as search intensity of workers which in turn affects bargained wages causing further feedback effect via consumption demand on vacancy creation of firms, thus, ultimately affecting the aggregate labor market dynamics. Using the now cast errors of professional forecasters, I use a sign-restricted VAR to identify noise shocks from the fundamental shocks in the data. I show that these noise shocks have a significant and more persistent effect on unemployment, vacancies and job-finding rate in the data compared to fundamental shocks. Noise shocks can explain a significant fraction of the volatility in unemployment and vacancies, consistent with the model’s implications.