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We introduce dynamic incentive contracts into a model of unemployment fluctuations.
Our main result is that wage cyclicality from incentives does not affect the
response of unemployment to productivity shocks. The response of unemployment is
the same, to a first-order, in two economies: one with flexible incentive pay, and another
with exogenously fixed wages. This equivalence is due to movements in effort.
Under the optimal incentive contract, firms’ profits do not change when wages fall,
because the effort of the worker falls too.
