Sometimes it feels like there are more business cycle theories than actual business cycles. Instead of introducing yet another theory, a recent paper by Stéphane Dupraz, Emi Nakamura, and Jón Steinsson may instead put an older theory back into the macroeconomics discussion: Milton Friedman’s “plucking model.” Their paper presents a search-theoretic foundation for Friedman’s plucking model and shows how the model continues to fit the United States data.
The plucking model, first presented in a 1964 NBER research summary and then tested again in a 1993 Economic Inquiry article, draws an analogy between economic contractions and disturbances to taut strings where “output is viewed as bumping along the ceiling of maximum feasible output except that every now and then it is plucked down by a cyclical contraction.” For Friedman, the most common plucking down came from contractionary monetary policy, but that is not the only plucking.
Like a plucked string, a large pull downward leads to a large swing back up. Friedman documented how the size of an economic contraction is correlated with the size of the subsequent expansion but not correlated with the size of the preceding expansion. If you see a big contraction in the data, say in 2007–9, Friedman’s model would predict that you will see a big expansion around 2010. However, if you see a large expansion in the data, you cannot predict a similar contraction will follow.
While Friedman’s original focus was on gross national product, Dupraz, Nakamura, and Steinsson focus on a related but distinct feature of the data: the movement of the unemployment rate. The authors describe a “plucking up” of unemployment followed by a return to a natural rate of unemployment around 5 percent. Figure 1, reproduced from the paper, shows the peaks and troughs of unemployment since 1948.
Contrary to the data on output, which consistently returns to a maximum output trend, unemployment does not regularly return to a minimum, specifically a minimum of 5 percent. Instead, unemployment sometimes bottoms out at 3 percent or sometimes at 6 percent. However, the authors document a correlation between a contraction and subsequent expansion (figure 2, left), while finding no correlation between an expansion and the subsequent contraction (figure 2, right). A plucking up of unemployment is followed by a return down with the same magnitude, but a decline in unemployment does not precede a rise of the same magnitude.
Why does the United States experience this relationship? As a theory, the authors present a search-and-matching model of the labor market. The searching and matching implies that once an employee is matched with an employer, the employee has some bargaining power over wages. The employer cannot simply fire the employee and find someone else. As the authors put it, “good shocks mostly lead to increases in wages, while bad shocks mostly lead to increases in unemployment.”
The model put forward by Dupraz, Nakamura, and Steinsson is not the only explanation for the correlation between large unemployment increases and declines. Similarly, Friedman’s model wasn’t the only way to understand the movements of output. For example, Roger Garrison argued in 1993 that the data that Friedman used to draw his conclusions are perfectly consistent with an Austrian theory of the business cycle. Nevertheless, Dupraz, Nakamura, and Steinsson are to be commended for putting an empirical phenomenon and elegant model on the table for discussion.