Time-Varying Wage Risk, Incomplete Markets, and Business Cycles

Abstract

Idiosyncratic wage risk exhibits cyclical variation. The present paper analyzes how such risk fluctuations affect business cycles using a heterogeneous-agent model with uninsured idiosyncratic wage risk and indivisible labor. I introduce risk fluctuations as uncertainty shocks and calibrate those shocks to the U.S. micm-level wage data. When moved by both uncertainty and aggregate TFP shocks, the model generates a weakly negative correlation between total hours worked and average labor productivity and large fluctuations in the labor wedge close to those in the U.S. economy. Without uncertainty shocks, hours and productivity comove strongly and the labor wedge varies little.