Throughout the economy's ups and downs, people decide whether to be in the labor force or to be “nonparticipants.” These decisions and their impact are increasingly being studied by economists. Nonparticipation differs from unemployment in that unemployed workers by definition carry out an active job search, while nonparticipants are out of the labor force, whether it be because they are retired or disabled, do unpaid work in the home exclusively, or are discouraged workers, choosing not to enter the job market due to a perceived lack of job prospects. The importance of labor force participation in understanding unemployment dynamics has been raised by Fed officials in recent years. For example, in a 2014 speech, Fed Chair Janet Yellen spoke of the need to better understand cyclical (as well as structural) factors influencing labor force participation rates when trying to estimate the degree of slack in the labor market.1
Fujita and Isabel Cairó and Camilo Morales-Jiménez of the Board of Governors of the Federal Reserve System explore the cyclical patterns of labor market transitions between employment, unemployment, and nonparticipation in their working paper “The Cyclicality of Labor Force Participation Flows: The Role of Labor Supply Elasticities and Wage Rigidity” (2020).2 They observe the pace at which people move in and out of the labor market in response to variations in overall economic activity. They model these labor force participation dynamics by connecting decisions at the household level with economywide labor market fluctuations.
They begin by studying the relationships between labor market transition rates, job vacancies, and real wages. The transition rates measure the pace at which individuals move between employment, unemployment, and nonparticipation. To understand the underlying factors at play in determining labor market dynamics, they employ a “search and matching model” that connects workers in search of jobs with employers who seek to fill jobs; they augment their model by considering labor force participation decisions. Their model depicts representative households that must decide whether to participate in the labor market or engage in home production. The authors explain that people weigh this participation decision by considering how productive a household member is at home.3 The authors refer to this as the “participation margin,” which can be thought of as a threshold whereby those individuals that are more productive at home stay out of the labor market, and the less productive at home join the labor pool in search of a job. This participation margin has a direct effect on the size of the unemployment pool in the economy over the course of the business cycle.
The authors find that the decision to seek out work is countercyclical, meaning that people are less willing to join the ranks of the job-seeking unemployed during an economic expansion. The authors find two equally important reasons to explain why the participation rate runs counter to the business cycle. One factor is wage rigidities. In economic expansions, wages tend to rise only mildly despite the tighter labor market conditions, and therefore the return on market work is dampened. This creates a disincentive for people to participate in the labor force during expansions, thereby reducing the labor force participation rate during expansionary periods.
A second factor has to do with how households value home or “nonmarket” activities at different points in the business cycle. The authors find that, during economic expansions, people value more leisure activities and home production. Therefore, they are less likely to join the unemployment pool in search of a job in good economic times. The authors note that this result might seem counterintuitive because it is easier to find a job in an economic expansion, which provides an incentive to join the workforce. However, they find that the overriding factor influencing labor force participation decisions is that people value home activities more when the economy is stronger. The authors find that the opposite occurs during a recession, pushing up labor force participation rates. People may need to join the labor pool—for example, when a working member of the household loses hours or a job during a downturn, providing an incentive for another household member to join the labor pool to compensate for the loss in income.
In their conclusion, Cairó, Fujita, and Morales-Jiménez explain that the “unemployment pool expands in downturns not only because the pace of job loss increases and the pace of hiring slows down, but also because the entry rate into the pool from nonparticipation increases and the exit rate to nonparticipation slows down.” Their results provide important inputs for policymakers as they implement plans to maximize employment under varied macroeconomic conditions.