The supply of skills in the labor force and aggregate output volatility

The cyclical volatility of US gross domestic product suddenly declined during the early 1980s and remained low for over 20 years. I develop a labor search model with worker heterogeneity and match-specific costs to show how an increase in the supply of high-skill workers can contribute to a decrease in aggregate output volatility. In the model, firms react to changes in the distribution of skills by creating jobs designed specifically for high-skill workers. The new worker–firm matches are more profitable and less likely to break apart due to productivity shocks. Aggregate output volatility falls because the labor market stabilizes on the extensive margin. In a simple calibration exercise, the labor market based mechanism generates a substantial portion of the observed changes in output volatility.

► Develop a labor search model with worker skill heterogeneity.
► Firms react to changes in the distribution of skills by creating jobs designed for high-skill workers.
► New matches are more profitable and less likely to break apart due to shocks.
► Aggregate output volatility falls because the labor market stabilizes on the extensive margin.