Employment Fluctuations with Downward Wage Rigidity: The Role of Moral Hazard

Abstract:     
We study the cyclical dynamics of job creation and destruction when workers' effort is not perfectly observable. The no-shirking constraint may amplify fluctuations in hiring by making firms' surplus share procyclical, and may cause a burst of inefficient firing when a downturn begins. But quantitatively, it mainly raises the cost of motivating marginal workers in booms, since firms cannot commit to keep them in recessions, and thereby strongly damps the countercyclical fluctuations in the separation rate. This implies a robust Beveridge curve, but casts doubt on Ramey and Watson's (1997) “contractual fragility” mechanism and worsens Shimer's (2005a) “volatility puzzle”.

Number of Pages in PDF File: 30

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