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Accounting for Idiosyncratic Wage Risk Over the Business Cycle

  • Alisdair McKay


    (Department of Economics, Boston University)

  • Tamas Papp


    (Institute for Advanced Studies, Vienna.)

We demonstrate that wage volatility, measured as the cross-sectional variance of wage changes in PSID data, is counter-cyclical. We quantify this relationship by estimating the re- gression coecient of wage volatility on the national unemployment rate in a multilevel Bayesian model, then decompose this coefficient into three main factors. During a recession, wage volatil- ity increases substantially among those workers experiencing spells of unemployment: the cycli- cal changes in the variance within this group explain about 55% of the cyclical variation in wage volatility. The variance within the group not experiencing unemployment explains 18%. Finally, an increase in the fraction of workers experiencing unemployment explains 25%. We show that a calibrated search-and-matching model of the labor market with on-the- job search gives a good account of the cyclical variation in idiosyncratic wage risk among those experiencing unemployment and of the composition effect over the business cycle. We show that in our model, this result is driven mostly by uctuations of the reservation wage in response to labor market conditions.

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Paper provided by Boston University - Department of Economics in its series Boston University - Department of Economics - Working Papers Series with number WP2011-028.

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Length: 49 pages
Date of creation: Jan 2011
Date of revision:
Handle: RePEc:bos:wpaper:wp2011-028
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