Uncertainty, Wages, and the Business Cycle

We show that limited wage flexibility in economic downturns generates strong and state-dependent amplification of uncertainty shocks. It also explains 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. Non-linear local projections and VAR estimates support the model predictions. 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.