The macroeconomics of hedging income shares

The recent debate about the falling share of labor income has brought attention to the trends in income shares, but less attention has been devoted to their variability. In this paper, we analyze how their fluctuations can be insured against between workers and capitalists, and the corresponding implications for financial markets. We study a neoclassical growth model with aggregate shocks that affect income shares and financial frictions that prevent firms from fully insuring idiosyncratic risk. We examine theoretically how aggregate risk sharing is distorted by the combination of idiosyncratic risk and moving shares. Accumulation of safe assets by firms and risky assets by households emerges naturally as a tool to insure income shares’ risk. We calibrate the model to the U.S. economy and show that low interest rates, rising capital shares, and accumulation of safe assets by firms and risky assets by households can be rationalized by persistent shocks to the labor share.