Business Cycles with Costly Search and Recruiting

A business cycle model is developed in which output is traded on Lucas-Phelps islands and labor services on each island are exchanged through costly search and recruiting with transactions externalities. The model exhibits persistent involuntary unemployment and inefficient equilibria, even though there are no nominal rigidities and no unexploited privately attainable gains from trade. It also exhibits employment fluctuations without any real-wage fluctuations. It yields a Lucas aggregate-supply curve (to a linear approximation). It also implies that the natural rate of unemployment depends positively upon the variability and persistence of relative price shocks.