The Cyclical Behavior of Unemployment and Wages under Information Frictions∗

I propose a new mechanism for sluggish wages based on workers’ noisy information about the state of the economy. Wages do not respond immediately to a positive aggregate shock because workers do not (yet) have enough information to demand higher wages. This increases firms’ incentives to post more vacancies, which makes unemployment volatile and sensitive to aggregate shocks. The model is robust to two major criticisms of existing theories of sluggish wages and volatile unemployment: flexibility of wages for new hires and pro-cyclicality of the opportunity cost of employment. Calibrated to U.S. data, the model explains 70% of unemployment volatility. ∗I am especially grateful to Boragan Aruoba, Luminita Stevens, John Haltiwanger, and John Shea for their valuable suggestions and support. I would also like to thank Katherine Abraham, Pablo Cuba-Borda, Sebnem Kalemli-Ozcan, Ethan Kaplan, Felipe Saffie, Marisol Rodriguez-Chatruc, Loukas Karabarbounis, Ellen McGrattan, Ryan Michaels, Iourii Manovskii and seminar participants at the University of Maryland, University of Pennsylvania, University of Minnesota and Federal Reserve Bank of Philadelphia for valuable suggestions and helpful comments. The views expressed in this paper are solely the responsibility of the author and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or of anyone else associated with the Federal Reserve System. †Contact: [email protected]