The Great Moderation and Changes in the Structure of Labor Compensation

A shift in the correlation structure of U.S. macroeconomic series has been documented by Galí and Gambetti (2009) with corresponding changes in the dynamic responses to shocks. We provide an explanation of these findings based on the observed change in the structure of labor compensation and, in particular, on the higher incidence since 1980s of performance-related pay schemes, which has increased the performance sensitivity of compensation. We capture this feature in a DSGE model of the New Keynesian type and show that this interpretation alone can account for the observed changes in the pattern of responses to shocks. In particular, with a higher sensitivity of compensation to workers performance, the response of labor productivity to a non-technology shock switches sign from positive to negative values and the contractionary effect on hours of a technology shock becomes of a smaller size in absolute terms. Alternative explanations of the Great Moderation based on structural changes fall short of accounting for both these documented changes in the dynamic responses to shocks.