Time-varying wage risk, incomplete markets, and business cycles

Abstract

Idiosyncratic wage risk exhibits cyclical variation. This study analyzes how such risk fluctuations affect business cycles. I use a heterogeneous agent model with uninsured idiosyncratic wage risk, indivisible labor, and a borrowing constraint. I introduce risk fluctuations as uncertainty shocks and calibrate those shocks using micro-level wage data in the United States. I find that uncertainty shocks affect labor market dynamics through ex-ante uncertainty and ex-post distribution effects. In particular, uncertainty shocks mainly influence the employment of low-productivity individuals, generating negative comovement between total hours worked and average labor productivity. Including uncertainty shocks in addition to aggregate total factor productivity shocks helps the model account for the weakly negative hours–productivity correlation and large fluctuations in the labor wedge seen in the United States.