Time-Varying Wage Risk, Incomplete Markets and Business Cycles

Idiosyncratic wage risk exhibits cyclical variation. I show that such risk variation is quantitatively relevant to business cycles by using a heterogeneous-agent, incomplete asset markets model with idiosyncratic wage risk and indivisible labor. I calibrate the model's risk variation to micro-level wage data. When moved by shocks to idiosyncratic wage risk and aggregate TFP, 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 seen in the U.S. data. When uncertainty shocks are removed, hours and productivity comove strongly and the labor wedge varies little.