Heterogeneity and Aggregation: Implications for Labor-Market Fluctuations

We demonstrate that aggregate employment and consumption can increase without a corresponding movement in productivity in a model with heterogeneous agents where the only aggregate disturbance is a productivity shock. The interaction between incomplete capital markets and indivisible labor results in a low employment-productivity correlation and creates a time-varying wedge between the marginal rate of substitution (for commodity consumption and hours) and productivity. Our results caution against viewing the measured wedge as an inefficiency due to a failure of labor-market clearing or as a fundamental driving force behind business cycles. (JEL D31, E32, J22, J24, J31)