The interaction of incomplete markets and sticky nominal wages is shown to magnify business cycles even though these two features—in isolation—dampen them. During recessions, fears of unemployment stir up precautionary sentiments that induce agents to save more. The additional savings may be used as investments in both a productive asset (equity) and an unproductive nominal liquid asset. The desire to hold the nominal liquid asset puts deflationary pressure on the economy which, provided that nominal wages are sticky, increases labor costs, and reduces firm profits. Lower profits repress the desire to save in equity, which increases (the fear of) unemployment, and so on. This mechanism causes the model to behave differently from its complete markets version and is quantitatively important even if monetary policy counteracts the desire to hold more of the liquid asset by lowering the interest rate. The deflationary pressure yields a mean-reverting reduction in the price level, which implies an increase in expected inflation and a decrease in the expected real interest rate even if the policy rate does not adjust. Thus, our mechanism is different from the typical zero lower bound argument. Due to the deflationary spiral, our model also behaves differently from its incomplete market version without aggregate uncertainty, especially in terms of the impact of unemployment insurance on average employment levels.
This paper shows that higher uncertainty increases unemployment in the US by increasing the separation rate and decreasing the job-finding rate. Standard search and matching models predict an increase in the job-finding rate instead. I develop a search and matching model in which heterogeneous firms are subject to decreasing returns to scale and can hire multiple workers. In this framework, job flows (job creation and job destruction) do not necessarily coincide with worker flows (hires and separations). Costly job creation is key to obtaining a decrease in the job-finding rate after an increase in uncertainty.
I analyse the inefficiencies created in a search and matching model that allows for on-the-job search. First, the Hosios rule for the efficient level of the worker's bargaining power is adapted in a simple model. As the average gain of a new match is lower when some job seekers already have a job, the efficient level of labour market tightness should be lower and the worker's bargaining power higher than in a model devoid of on-the-job search. Second, the decision of when to perform on-the-job search is endogenised. It is shown that there is too much on-the-job search taking place because workers do not fully incorporate their current firms' loss when they quit. When partial wage commitment is introduced, the bargaining set becomes non-convex. Using a suitable bargaining process, I prove that wage commitment improves the efficiency of the on-the-job search decision and that the efficient level can be obtained.