Labor Market Dynamics under Long Term Wage Contracting
Recent research seeking to explain the strong cyclicality of US unemployment emphasizes the role of wage rigidity. This paper proposes a micro-founded model of wage rigidity – an equilibrium business cycle model of job search, where risk neutral firms post optimal long-term contracts to attract risk averse workers. Equilibrium contracts feature wage smoothing, limited by the inability of parties to commit to contracts. The model is consistent with aggregate wage data if neither worker nor firm can commit, producing too rigid wages otherwise. Wage rigidity does not lead to a substantial increase in the cyclical volatility of unemployment.
This paper introduces risk averse workers into a search and
matching model and considers the quantitative performance of the model over the business cycle.
Wages are determined by long term contracts between workers and firms, with firms providing insurance
to workers against variation in labor productivity. The insurance motive delivers endogenous wage rigidity, the
extent of which depends on the contracting environment.
The quantitative results show that the
model has no trouble producing wages that are too rigid relative to data.
The key parameter governing how much volatility the model produces not only in unemployment and vacancies but also wages, is the drop in consumption
for the unemployed.
In addition, explaining the volatility of wages requires
that contracting is limited by the ability of both the worker and firm to end the employment relationship unilaterally.
These results contrast with Shimer (2005) and Hall (2005), who argue for introducing rigid wages into search and matching models.
business cycles, unemployment, wage rigidity, search
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