Sectoral shocks and movement costs: Effects on employment and welfare

In this paper we provide a general equilibrium model of a two-sector economy which accounts for low employment due to the incomplete responses of workers to sectoral shocks. This model is used to reconcile the seemingly contradictory results of macro and micro evidence, namely that sectoral shocks explain fluctuations of employment even though we do not observe cyclical movements of labor across sectors. We further find that increasing the frequency of sectoral shocks, holding the magnitude of the shocks fixed, decreases total employment. This allows us to account for the phenomena that the unemployment rate itself has been higher since 1970, a period characterized by an increased frequency of sectoral shocks. We also study the theoretical implications of two opposite policies: one which subsidizes mobility and the other which eliminates the partial insurance provided in the model. The former increases employment and welfare while the latter increases employment but reduces welfare.