The role of wage expectations in the labor market
What this paper finds — and why it matters
This paper develops a Mortensen-Pissarides (DMP) search and matching model with internally rational (IR) agents who hold subjective beliefs about wages rather than perfect knowledge of the Nash bargaining outcome. The standard DMP model struggles with two empirical regularities: high volatility of U.S. labor market variables relative to productivity, and a near-zero correlation between labor market tightness and productivity post-1989. The IR model significantly improves alignment with U.S. labor market data relative to the standard rational expectations benchmark, by generating a self-referential belief mechanism: shifts in beliefs about the future returns to labor affect current wages, which agents use to update beliefs. Wage expectations in the model are consistent with European Commission professional forecasters data, and an econometric test rejects the rational expectations null hypothesis for survey real wage expectations.
Summary based on a working paper version, AI-assisted and human-reviewed. See the linked published article for the authoritative version.
Q1. What is internal rationality and how does it differ from standard rational expectations?
Internal rationality (IR) means agents know all internal aspects of their optimization problem and maximize their objectives given their knowledge, but lack perfect information about the equilibrium wage function that emerges from Nash bargaining; they therefore hold subjective beliefs about wages. Under standard rational expectations, workers and firms know the exact wage function from Nash bargaining. Under IR, they have limited foresight about the outcome of wage negotiations and use a subjective model to form wage expectations. This is a small but disciplined departure from RE: the paper considers belief systems implying only a small deviation from rational expectations that match aspects of survey wage expectations.
Q2. What is the empirical failure of the standard DMP model that motivates the paper?
The standard DMP model fails on two counts: it cannot reproduce the high observed volatility of unemployment, vacancies, and market tightness relative to productivity, and it cannot generate the near-zero post-1989 correlation between productivity and labor market tightness. The first failure—the Shimer (2005) puzzle—has attracted extensive research, but the near-zero tightness-productivity correlation has been largely neglected. The paper shows that allowing for small deviations from rational expectations in the form of internal rationality resolves both puzzles simultaneously.
Q3. What is the self-referential belief mechanism and how does it generate extra dynamics?
The model has a self-referential mechanism: shifts in beliefs about future returns to labor affect current wages, and agents use realized wages to update their beliefs about future wages; this creates an additional dynamic source beyond technology shocks that helps match the data. When firms and workers revise beliefs about future wages upward, current wages rise through the Nash bargaining outcome (since reservation values of both parties shift); this realization then feeds back into updating beliefs, generating wage and employment dynamics not tied to current productivity. This mechanism provides a microfoundation for previous adaptive learning models of unemployment.
Q4. What is the empirical validation of the model’s wage expectations?
Wage expectations in the IR model are validated against survey data from European Commission professional forecasters, and an econometric test rejects the rational expectations null hypothesis for real wage expectations from survey data. The consistency between model-implied and surveyed wage expectations provides external validation for the IR departure from RE, showing that the subjective beliefs assumed in the model correspond to beliefs actually held by professional forecasters rather than to arbitrary deviations.
Key concepts
internal rationality (IR) : a bounded rationality concept in which agents fully optimize given their beliefs and knowledge of their own decision problem, but lack perfect knowledge of equilibrium objects (here, the wage function emerging from Nash bargaining); allows small, disciplined deviations from rational expectations. DMP model : the Mortensen-Pissarides-Diamond search and matching model; the standard theory of equilibrium unemployment; criticized for generating insufficient labor market volatility relative to productivity (the Shimer puzzle) and for counterfactual positive tightness-productivity correlation. belief shock : an exogenous shift in agents’ subjective beliefs about future wages; generates employment and wage dynamics independently of current productivity shocks via the self-referential mechanism; introduced as an additional structural shock in the IR-DMP model.