Discussion Paper Details

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Title: Uncertainty, Wages, and the Business Cycle

Author(s): Matteo Cacciatore and Federico Ravenna

Publication Date: May 2020

Keyword(s): Business cycle, occasionally binding constraints, uncertainty and unemployment

Programme Area(s): Monetary Economics and Fluctuations

Abstract: We show that occasional deviations from efficient wage setting generate strong and state-dependent amplification of uncertainty shocks and can explain the cyclical behavior of empirical measures of uncertainty. Central to our analysis is the existence of matching frictions in the labor market and an occasionally binding constraint on downward wage adjustment. The wage constraint enhances the concavity of firms' hiring rule, generating an endogenous profit-risk premium. In turn, uncertainty shocks increase the profit-risk premium when the economy operates close to the wage constraint. This implies that higher uncertainty can severely deepen a recession, although its impact is weaker on average. Additionally, the variance of the unforecastable component of future economic outcomes always increases at times of low economic activity. Thus, measured uncertainty rises in a recession even in the absence of uncertainty shocks.

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Bibliographic Reference

Cacciatore, M and Ravenna, F. 2020. 'Uncertainty, Wages, and the Business Cycle'. London, Centre for Economic Policy Research.