Stubborn Beliefs in Search Equilibrium

Abstract

I study a search equilibrium model of the labor market in which workers have stubborn beliefs about their labor market prospects, i.e. beliefs about their probability of (cid:133)nding a job and the wage they will earn that do not respond to aggregate (cid:135)uctuations in fundamentals. I show that, when workers have stubborn beliefs, the response of the wage bargained by a (cid:133)rm and a worker to aggregate shocks is dampened. As a result, the response of labor market tightness, job-(cid:133)nding probability, unemployment and vacancies to aggregate (cid:135)uctuations is ampli(cid:133)ed. I show that stubborn beliefs generate cyclical ine¢ ciencies in the labor market that can be corrected with countercyclical employment subsidies. I (cid:133)nd that the response of the labor market to negative shocks is the same even if only a small fraction of workers has stubborn beliefs. In contrast, if the fraction of workers with stubborn beliefs is small, the response of the labor market to positive shocks is approximately the same as under rational expectations.