By Yongsung Chang, Sun-Bin Kim, Kyooho Kwon and Richard Rogerson
Standard heterogeneous agent macro models that highlight idiosyncratic productivity shocks do not generate the near zero cross-sectional correlation between hours and wages found in the data. We ask whether matching this moment matters for business cycle properties of these models. To do this we explore two extensions of the model in Chang et al. (2019) that can match this empirical cross-section correlation. One of these departs from the assumption of balanced growth preferences. The other introduces an idiosyncratic shock to the opportunity cost of market work that is highly correlated with the shock to market productivity. While both extensions can match the empirical correlation, they have large and opposing effects on the cyclical volatility of the labor market. We conclude that the cross-sectional moment is important for business cycle analysis and that more work is needed to distinguish the potential mechanisms that can generate it.
The time series correlation between hours and wages has been a real struggle with representative agent business cycle model. Now it pops up again as a stumbling block with heterogeneous agents, this time as a cross-sectional correlation. I expect this to be the first of many papers on the subject.