Joe Hazzell, London School of Economics

"Bonus Question: How Does Incentive Pay Affect Wage Rigidity?"


Wage rigidity occupies a central role in business cycle models. However, the relevant notion of wage rigidity is unclear because in the data, base wages appear rigid but non-base wages, such as bonuses, are flexible in the data. This paper studies how incentive pay affects unemployment and inflation dynamics by embedding a general dynamic principal-agent problem into macro business cycle models. We show that a Diamond-Mortensen-Pissarides labor search model with flexible incentive pay exhibits identical first-order unemployment dynamics compared with a simple model with exogenously fixed wages \citep (Hall, 2005) calibrated to the same steady state moments. Similarly, in a New Keynesian model, incentive pay generates the same Phillips Curve relation between price inflation and unemployment as does a fixed wage model. Thus incentive pay is not relevant "wage flexibility'' for unemployment or inflation dynamics.

Contact person: Antoine Bertheau