According to search and matching theory, a greater availability of unemployed workers should make it easier for a firm to fill a vacancy, but more vacancies at other firms should make recruitment more difficult. Simulating a theoretical model of a firm facing perfect competition in the product market and no convex adjustment costs (standard assumptions in the search and matching literature), I find that shocks to vacancies and unemployment lead to economically significant employment responses. Simulating a more realistic model with imperfect competition in the product market and convex adjustment costs, I find small employment effects of shocks to vacancies and unemployment. In particular, shocks to the number of unemployed seem to be unimportant. Estimating an employment equation on a panel of Swedish firms, I find that neither the number of unemployed workers nor the number of vacancies in the local labor market is important for firms’ employment decisions.

To explain the high and persistent unemployment rate in the United States during and after the Great Recession, this effort develops and estimates a dynamic stochastic general equilibrium model with search and matching frictions and shocks to unemployment benefits and matching efficiency. It finds that unemployment benefits play an important role in the cyclical movement of unemployment through their effects on labor demand, a channel overlooked in previous studies. From the second half of 2008 to 2011, extended unemployment benefits may have increased the overall unemployment rate by one percentage point. In contrast, matching efficiency changes had less effect on the cyclical movement of unemployment for the same period, but significantly slowed down the recovery after 2012.

This paper embeds labor market search frictions into a New Keynesian model with financial frictions. The econometric estimation establishes that labor market frictions substantially improve the empirical fit of the model. The effect of the interaction between labor and financial frictions on aggregate fluctuations depends on the nature of the shock. For monetary policy, technology, and entrepreneurial wealth shocks, labor market frictions amplify the effect of financial frictions, because robust changes in hiring lead to persistent movements in employment and return on capital that reinforce the original effect of financial frictions. For cost-push, labor supply, marginal efficiency of investment, and preference shocks, labor market frictions dampen the effect of financial frictions by reducing the real cost of repaying existing debt, which lowers the external finance premium.

Recent U.S. evidence suggests that the response of labor share to a productivity shock is characterized by countercyclicality and overshooting. These findings cannot be reconciled easily with existing business cycle models. We extend the Diamond–Mortensen–Pissarides model of search in the labor market by considering strategic interactions among an endogenous number of producers, which leads to countercyclical price markups. Although Nash bargaining delivers a countercyclical labor share, we show that countercyclical markups are fundamental to address the overshooting. On the contrary, we find that real wage rigidity does not seem to play a crucial role in the dynamics of the labor share of income.

To identify the labor market reforms that offer the highest payoff, we develop a medium-scale two-country model representing a currency union featuring real and nominal rigidities and heterogeneous labor market frictions. A labor market reform is modeled as a permanent structural change in the labor market institutions. We find that changes in the domestic labor market can have drastic welfare implications for both countries. Welfare improvements are observed when a worker (a firm) is more likely to find a job (a worker) or when jobs are less likely to be destroyed. In addition, labor market heterogeneity has sizeable effects on the level of welfare gains. The more flexible the foreign labor market, the higher its welfare. Finally, we show that (i) the way the monetary authorities conduct their policy has negligible welfare effects and (ii) matching frictions can offset the negative effect of price rigidities in the economy.