Labor supply shocks affect production, wages, and unemployment --- VAR economic model proves

The main result that emerges from our analysis is that both our identified labor market shocks play a significant role in explaining economic fluctuations. These shocks account for 20% of output fluctuations on impact and almost 80% in the long run. Moreover, they explain around 50% of unemployment fluctuations at short horizons and 80% at long horizons. The wage bargaining shock is more important at short horizons (especially for unemployment), whereas the labor supply shock is crucial to capture macroeconomic dynamics in the long run (both for output and unemployment). Put differently, our findings suggest that shocks generating the type of co-movements between variables that are typically associated with wage markup shocks are important both in the short run and in the long run. Moreover, they are not the only driving force of unemployment in the long run. Thus, we do not find support for the polar assumptions on the role of wage markup shocks made in the previous literature (cf. Galí et al., 2011; Justiniano et al., 2013).

An important role for shocks originating in the labor market in driving economic fluctuations is in keeping with results from previous VAR studies that include labor supply shocks (without, however, disentangling wage bargaining shocks). In Shapiro and Watson (1988), the labor market shock explains on average 40% of output fluctuations at different horizons and 60% of short-term fluctuations in hours (80% in the long run). In Blanchard and Diamond (1989), shocks to the labor force explain 33% of unemployment volatility in the very short run and around 15% in the long run. In Chang and Schorfheide (2003) labor-supply shifts account for about 30% of the variation in hours and about 15% of output fluctuations at business cycle frequencies. Peersman and Straub (2009) do not report the full variance decomposition in their VAR but the limited role of technology shocks in their model let us conjecture an important role for the two remaining shocks, that is, demand and labor supply. We conclude that the available VAR evidence is reinforced by our results. Although the structural interpretation of labor supply and wage bargaining shocks remains an open question, our model suggests that supply shocks that move output and real wages in opposite directions play a significant role in macroeconomic dynamics.