Productivity shocks, dynamic contracts and income uncertainty.’ Tech. rep., Working paper

Please download the latest version at lamadon.com/lamadonjmp.pdf This paper examines how employer and worker specific productivity shocks transmit to wage and employment in an economy with search frictions and firm commitment. I develop an equilibrium search model with worker and firm shocks and characterize the optimal contract offered by competing firms to attract and retain workers. In equilib-rium risk-neutral firms offer risk-averse workers contingent contracts where payments are back-loaded in good times and front-loaded in bad ones: the combination of search frictions, productivity shocks and private worker actions results in partial insurance against firm and worker shocks. I estimate the model on matched employer-employee data from Sweden, using information about co-workers to separately identify firm spe-cific and worker specific earnings shocks. Preliminary estimates suggest that firm level shocks are responsible for about 20 % of permanent income fluctuations, the remain-ing being accounted for by individual level shocks (30 % to 40%) and by job mobility (40 % to 50%). The wage contract attenuates 80 % of individual productivity shocks but passes through 30 % of firm productivity fluctuations