Macroeconomic Risk and the Labor Share of Income – Master Projects 2014
Editor’s note: This post is part of a series showcasing Barcelona GSE master projects by students in the Class of 2014. The project is a required component of every master program.
Macroeconomic Risk and the Labor Share of Income
This paper suggests a novel explanation for variations in the labor share of income: the change in the variance and covariance of macroeconomic shocks over time. I present a model of the labor market that links the labor share with macroeconomic risk. In an economy where firms contract nominal wage payments in advance, real wages and profits fluctuate with unexpected inflation shocks. Consequently, both workers and capital investors demand risk premia that depend on the variance of inflation and the covariance of productivity and inflation shocks, respectively. If workers are heterogeneous with regard to their risk aversion and firms pay each his reservation wage, then this model implies that the equilibrium labor share of income depends negatively on these inflation and covariance risk factors. Using panel data for 23 OECD countries from 1975 to 2011, I show that these theoretical predictions also hold empirically: The variance of inflation and the covariance of real GDP growth with inflation explain a substantial part of the variation in the labor share, even after controlling for other potential determinants of the factor shares of income.
Read the full paper or view slides below: