Imperfect information, lagged labor adjustment and the Great Moderation

This paper first documents the increase in the time lag with which labor
input reacts to output fluctuations ("the labor adjustment lag") that is visi-
ble in US data since the mid-1980s. We show that a lagged labor adjustment
response is optimal in a setting where there is uncertainty about the persis-
tence of shocks and where labor input is costly to adjust. We then present
evidence that both the nature of shocks hitting the economy as well as labor
adjustment costs may have changed during the 1980s in a direction that could
explain the observed increase in the lag. Finally, we argue that the increased
labor adjustment lag has the potential to explain some macroeconomic puz-
zles that characterize post-1984 US data, such as the reduced procyclicality of
labor productivity and the reduction in output volatility (known as the Great
Moderation).

Key words: imperfect information, labor adjustment, jobless growth, option
value of waiting, Great Moderation
JEL-classifications: E24, E32, J23, J24