Uncertainty and Unemployment Revisited : The Consequences of Financial and Labor Contracting Frictions

I build a novel model to study how uncertainty shocks to firm-level productivity affect unemployment through the financial channel of incomplete labor contracts. My model can explain 90% of the increase in unemployment during the Great Recession, twice the magnitude in Schaal (2017). The key idea is that incomplete labor contracts imply wage insensitivity to firms’ idiosyncratic shocks. Hence, wage bills are debt-like commitments by firms to workers, which firms are less likely to take on when uncertainty is high, so they hire fewer workers and unemployment increases. The model’s performance in explaining unemployment deteriorates greatly if either financial frictions or uncertainty shocks are absent. Given the model’s quantitative success, I use it to analyze the impact of the United States and German labor market policies during recent recessions. The U.S. policy raises unemployment benefits, making it more expensive for firms to pay wages, amplifying the recession. Germany subsidizes firms’ wage bills, which outperforms the U.S. policy but still yields a negative impact since the misallocation losses outweigh the gains from insuring firms