The paper develops a model of directed search on the job in which transitions of workers between unemployment and employment and across employers are driven by heterogeneity in the quality of firm-worker matches. The equilibrium is such that the agents’ value and policy functions are independent of the endogenous distribution of workers across employment states. Hence, the model can be solved outside of the steady state and used to measure the effect of cyclical productivity shocks on the labor market. Productivity shocks are found to generate large fluctuations in workers’ transitions, unemployment, and vacancies when matches are experience goods, but not when matches are inspection goods.

We study the long-run relation between money (inflation or interest rates) and unemployment. We document positive relationships between these variables at low frequencies. We develop a framework where money and unemployment are modeled using explicit microfoundations, providing a unified theory to analyze labor and goods markets. We calibrate the model and ask how monetary factors account for labor market behavior. We can account for a sizable fraction of the increase in unemployment rates during the 1970s. We show how it matters whether one uses monetary theory based on the search-and-bargaining approach or on an ad hoc cash-in-advance constraint.