A coincidence in time between the volatility break associated with the "Great Moderation" and large changes in the pattern of conditional and unconditional correlations among output, hours and labor productivity has been detected by Galí and Gambetti (2009). We provide a novel explanation for these findings, based on major changes occurred in the U.S. design of labor compensation around the mid- 1980s. These include a substantial increase in the incidence of performance pay coupled with a higher responsiveness of real wages to the business cycle. We capture this shift in the structure of labor compensation in a Dynamic New Keynesian (DNK) model and show that, on its own, it generates the disappearance of the procyclical response of labor productivity to non-technology shocks and a reduction of the contractionary effects on hours worked of technology shocks. More- over, it accounts for a large fraction of the observed drop in output volatility after 1984 and for most of the observed changes in unconditional correlations.
Published in 2013 in: Journal of Economic Dynamics and Control, v. 37, 12, pp. 2796-2813
