This paper studies the effects of moral hazard on employment and wage dynamics using a continuous-time competitive search model with aggregate productivity shocks. Unobservable idiosyncratic shocks require employers to design dynamic optimal contracts to incentivize workers to exert effort. To quantify the magnitude of the underlying information friction, the model is calibrated to match the volatility of individual worker performance pay residuals in PSID. Unemployment rate volatility is 8 times larger than when the moral hazard problem is absent. The model endogenously generates counter-cyclical wage dispersion. A novel channel explains these findings: higher aggregate productivity reduces the importance of unobservable idiosyncratic shocks, facilitating the detection of shirking. With a relaxed incentive constraint, firms are more willing to post vacancies and have less need to expose workers to risk.
|Publication status||In preparation - Oct 2022|