Abstract
Beginning with Shimer (2005) and Hall(2005), a recent branch of the business cycle literature has explored the role of wage rigidity in accounting for the statistical characteristics of key labor market variables; in particular high vacancy and unemployment volatility and a high negative correlation between the two. As a further exploration, we extend the Mortensen-Pissarides structure of period-by-period Nash wage bargaining to an environment where there is labor force heterogeneity (permanently employed "insiders" and "outsiders" subject to separations) and limited asset market participation: insiders hold debt and all the firms' equity while outsiders hold only debt. We demonstrate that a reasonable calibration of the resulting model satisfactorily accounts not only for aggregate fluctuations in unemployment and vacancies and their cross correlations, but also for the observed wedge between variations at the intensive margin (hours per worker) and at the extensive margin (total hours). The model also achieves a satisfactory replication of the major financial return phenomena; namely, a high equity premium, a low risk free rate, appropriate return volatility levels, and an upward sloping tern structure. Relative aggregate volatility levels are in the correct relationship as well. The key to these results is the variable income insurance effectively provided by shareholders and given to workers arising from the interaction of Nash wage bargaining superimposed on the incomplete financial market structure.