Labor Contracts and Business Cycles

Abstract _ Tbis paper investigates tbe c1aim, ofien put fortb by Real Business Cycle proponents (e.g Prescott (1986», that tbe poor performance of tbeir models in matching real world aggregate labor market behavior are due to tbe fact that observed real wage payments do not correspond to tbe actual marginal productivity of labor but contain an insurance component wbich cannot be accounted for by tbe Walrasian pricing mecbanism. To test tbis idea we dispense with tbe Walrasian description of tbe labor market and introduce contractual arrangements between employees and employers. Assuming tbat tbe former are prevented froro accessing capital markets and are more risk averse tban tbe latter we use tbe tbeory ofoptimal contracts to derive an equilibrium relation between aggregate states of tbe economy and wage-Iabor outcomes. Tbis contractual arrangement is then embedded into a standard one-sector, stocbastic neoclassical growth model in order to look at tbe business cycle implications of tbe contractual hypotbesis. The resulting dynanllc equilibrium relations are tben parameterized and studied by means of standard numerical approximation techniques. The quantitative properties of our model appear to be somewhat encouraging. We have examined different contractual environments and in all circumstances tbe contracts-based equilibrium performs better than standard ones witb regard to tbe labor-market variables and at least as well witb regard to the otber aggregat