Time-Varying Wage Risk, Incomplete Markets, and Business Cycles

Idiosyncratic earnings risk shows cyclical variation. In order to analyze its implication with respect to labor market dynamics, this paper develops an incomplete asset markets model in which individuals make consumption-saving and employment choices each period in the presence of time-varying person-specific wage risk. I measure the model's risk variation using wage data in the Panel Study of Income Dynamics. When including variation in both idiosyncratic wage risk and aggregate total factor productivity, the model produces a weakly negative correlation between total hours worked and average labor productivity close to the U.S. data. In contrast, in the absence of wage risk fluctuations, the model generates a counterfactually strong positive correlation.