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May/June 1999, 
Vol. 81, No. 3
Posted 1999-05-01

Contract-Theoretic Approaches to Wages and Displacement

by Wouter J. den Haan, Garey Ramey, and Joel Watson

This article focuses on the contract theoretic underpinnings of wage adjustment and worker displacement in moral-hazard models of the labor market. The authors show that contracting imperfections play a key role in determining the fragility of employment relationships in the face of shocks to productivity, as well as influencing the form of worker compensation. Moreover, the responses of aggregate wages and employment to business-cycle shocks are sensitive to the structure of worker/firm contracting. Overall, the study establishes that the particular form of contracting imperfections can have major implications for economic outcomes. This highlights the importance of going beyond the reduced-form analysis of contracting that typifies much of the macroeconomics literature.