Workers' Reciprocity and the (Ir)relevance of Wage Cyclicality for the Volatility of Job Creation

In the last two decades advances in the theory of labour market fluctuations have emphasised the role of new hires' wage rigidity—rather than wage rigidity of existing workers—to explain the large volatility of unemployment observed in the data. However, recent evidence suggests that wages paid to newly hired workers are substantially pro-cyclical. By considering the effect that wage changes can have on workers' effort, and therefore on output, this paper provides two novel theoretical results. First, it is shown that the anticipation by firms of the effort response of new hires to wage changes can amplify the magnitude of shocks to the extent that, in contrast with the existing literature, the cyclicality of the hiring wage becomes irrelevant for their decision to hire new workers, and hence for the volatility of job creation. Second, it is shown that firms' expectation of existing workers' downward wage rigidity—and the anticipation of their negative reciprocity response to future wage cuts—does matter for the expected value of posting a new vacancy, and under certain conditions it may even reduce firms' incentive to hire.