Pecuniary externalities in economies with downward wage rigidity

A pecuniary externality in economies with downward nominal wage rigidity leads firms to hire too many workers in expansions, which leads to too much unemployment in recessions. When firms hire more workers, firms fail to internalize that competition for workers between firms pushes up the aggregate wage, which imposes a negative externality over other firms. The externality can be resolved by a macroprudential tax on labor in expansions. In the calibrated model, the tax reduces the welfare cost of downward nominal wage rigidity by up to 90%, as it makes the economy significantly less exposed to unemployment crises. (C) 2019 Elsevier B.V. All rights reserved.