Performance Pay and Shifts in Macroeconomic Correlations

A coincidence in time between the volatility break associated with the quot;Great Moderationquot; and large changes in the pattern of conditional and unconditional correlations among output, hours and labor productivity has been detected by Gali and Gambetti (2009). We provide a novel explanation for these findings, based on major changes occurred in the U.S. design of labor compensation around the mid-1980s. These include a substantial increase in the incidence of performance pay coupled with a higher responsiveness of real wages to the business cycle. We capture this shift in the structure of labor compensation in a Dynamic New Keynesian (DNK) model and show that, on its own, it generates the disappearance of the procyclical response of labor productivity to non-technology shocks and a reduction of the contractionary effects on hours worked of technology shocks. Moreover, it accounts for a large fraction of the observed drop in output volatility after 1984 and for most of the observed changes in unconditional correlations