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Lumpy Capital, Labor Market Search and Employment Dynamics over Business Cycles (No. E2009004)


Zhe Li*
April 2009

Abstract: This paper incorporates labor search frictions into a model with lumpy investment to explain a set of firm-size-related facts about the United States labor market dynamics over business cycles. Contrary to the predictions of standard models, we observe that job destruction is procyclical in small firms but countercyclical in large ones. Calibrated to U.S. data, the model generates this asymmetric pattern of employment dynamics in small versus large firms.
In the model, ex ante identical firms face random investment opportunities. Small firms are those that have a fewer number of workers either because they forgo investment for many periods and thus have a lower marginal labor productivity or because they fail to hire workers from a frictional labor market. If a small firm has a low level of capital stock, it tends to make lumpy investment and grow fast. Labor market frictions influence the small firm's investment decisions. If hiring is costly and time consuming, the small firms may give up some investment projects which they would undertake if the labor market were Walrasian. A fovarable aggregate productivity shock tightens the labor market and makes hiring more difficult. A tighter labor market hurts investing small firms, so investment increases more in large firms. As a result, a favorable productivity shock reallocates some workers from small to large firms, making procyclical job destruction in small firms possible. The paper contributes to a better understanding of firms' interactive investment behavior and employment behavior in the presence of factor market frictions, with the resulting aggregate employment dynamics in small versus large firms.
Keywords: labor market search, lumpy capital, business cycle, job creation, job destruction

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*Department of Economics, University of Toronto, 150 St. George Street, Toronto, Ontario, Canada, M5S 3G7 (email: