Reconciling Micro Elasticities and Macro Moments: Wedges and Insurance Through The Labor Market

Heterogeneous-agent models typically treat earnings as an exogenous endowment. This abstracts from the labor market, which insures households and forms earnings and their dispersion. We show analytically that incomplete markets introduce aggregate risk-misallocation wedges not only in consumption but also in labor supply, at the intensive and, once participation is conditioned on risk, the extensive margin, which carries a distinctive precautionary-attachment component with no counterpart in consumption. Quantitatively, across a family of two-asset models that differ only in their labor-market block, in whether labor supply is conditioned on risk and in the labor-demand friction (wage rigidity or indexation), the baseline business-cycle moments are similar across heterogenous and representative agent models; the labor supply margins match all micro elasticities (MPC, MPE, MPN), resolving their trilemma, and deliver countercyclical earning inequality endogenously; the labour demand frictions deliver the correct wage, employment, and productivity volatility ranking.