By Gabriel Chodorow-Reich and Johannes Wieland
We study the effect of mean-preserving idiosyncratic industry shocks on business cycle outcomes. We develop an empirical methodology using a local area’s exposure to industry reallocation based on the area’s initial industry composition and employment trends in the rest of the country over a full employment cycle. Using confidential employment data by local area and industry over the period 1980-2014, we find sharp evidence of reallocation contributing to worse employment outcomes during national recessions but not during national expansions. We repeat our empirical exercise in a multi-area, multi-sector search and matching model of the labor market. The model reproduces the empirical results subject to inclusion of two key, empirically plausible frictions: imperfect mobility across industries, and downward nominal wage rigidity. Combining the empirical and model results, we conclude that reallocation can generate substantial amplification and persistence of business cycles at both the local and the aggregate level.
The paper also shows that it is not sufficient to look at broad aggregates to determines the status of an economy. You also need to look at industry level data. Now the dilemma. Suppose there is some structural imbalance generating substantial unemployment. Higher inflation can then take care of the downward nominal rigidity friction in the affected industries and make the unemployed employable in those industries. But this does not solve the structural imbalance and just pushes the can down the road. Thus, should one inflate or not?