Uninsurable Individual Risk and the Cyclical Behavior of Unemployment and Vacancies

Enchuan Shao and Pedro Silos
Working Paper 2007-5
February 2007

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This paper is concerned with the business cycle dynamics in search-and-matching models of the labor market when agents are ex post heterogeneous. We focus on wealth heterogeneity that comes as a result of imperfect opportunities to insure against idiosyncratic risk. We show that this heterogeneity implies wage rigidity relative to a complete insurance economy. The fraction of wealth-poor agents prevents real wages from falling too much in recessions since small decreases in income imply large losses in utility. Analogously, wages rise less in expansions compared with the standard model because small increases are enough for poor workers to accept job offers. This mechanism reduces the volatility of wages and increases the volatility of vacancies and unemployment. This channel can be relevant if the lack of insurance is large enough so that the fraction of agents close to the borrowing constraint is significant. However, discipline in the parameterization implies an earnings variance and persistence in the unemployment state that result in a large degree of self-insurance.

JEL classification: E24, E32, J41, J63, J64

Key words: business cycles, labor market search

The authors thank Matt Mitchell, Elena Pastorino, Galina Vereschagina, and especially B. Ravikumar for many useful comments. This paper was previously circulated with the title “Is Uninsurable Individual Risk Important for the Cyclical Behavior of Unemployment and Vacancies?” The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.

Please address questions regarding content to Enchuan Shao, Department of Economics, University of Iowa, Iowa City, IA 52245, 319-335-1404, 319-335-1956 (fax), enchuan-shao@uiowa.edu, or Pedro Silos, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, GA 30309, 404-498-8630, 404-498-8956 (fax), pedro.silos@atl.frb.org.

For further information, contact the Public Affairs Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470, 404-498-8020.