Abstract:
We seek to provide a synthesis of the allocative effects of infrequent wage adjustment in long-term employment relationships subject to idiosyncratic shocks. We devise a new theory of wage dynamics that follow a “drunken walk,” whereby wages adjust minimally to satisfy participation constraints of firm and worker. The theory is amenable to analytical solution for the endogenous wage adjustment bounds, and is easily embedded into canonical models of aggregate labor market equilibrium, allowing a study of allocative implications for unemployment dynamics. A variety of extensions to accommodate an inflationary environment, on-the-job search, and costly wage cuts further allow an interpretation of recent evidence on nominal wage adjustment, base vs. non-base pay, and the possibility of inefficient separations.

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