We analyse a Bewley–Huggett–Aiyagari incomplete‐markets model with labour‐market frictions. Consumers are subject to idiosyncratic employment shocks against which they cannot insure directly. The labour market has a Diamond–Mortensen–Pissarides structure: firms enter by posting vacancies and match with workers bilaterally, with match probabilities given by an aggregate matching function. Wages are determined through Nash bargaining. We also consider aggregate productivity shocks and a complete set of contingent claims conditional on this risk. We use the model to evaluate a tax‐financed unemployment insurance scheme. Higher insurance is beneficial for consumption smoothing, but because it raises workers' outside option value, it discourages firm entry. We find that the latter effect is more potent for welfare outcomes; we tabulate the effects quantitatively for different kinds of consumers. We also demonstrate that productivity changes in the model—in steady state as well as stochastic ones—generate rather limited unemployment effects, unless workers are close to indifferent between working and not working; thus, recent findings are corroborated in our more general setting.

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We build a hybrid model of the aggregate labor market that features both standard labor supply forces and frictions in order to study the cyclical properties of gross worker flows across the three labor market states: employment, unemployment, and nonparticipation. Our goal is to assess the relative importance of frictions and labor supply in accounting for fluctuations in labor market outcomes. Our parsimonious model is able to capture the key features of the cyclical movements in gross worker flows and indicates an important role for both frictions and labor supply.

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We create a novel measure of job search effort starting in 1994 by exploiting the overlap between the Current Population Survey and the American Time Use Survey. We examine the cyclical behavior of aggregate job search effort using time series and cross-state variation and find that it is countercyclical. About half of the countercyclical movement is explained by a cyclical shift in the observable characteristics of the unemployed. Individual responses to labor market conditions and drops in wealth are important in explaining the remaining variation.