Abstract: Wage rigidity is a leading explanation for large unemployment fluctuations. However empirically, though base wages are rigid, non-base components of pay such as bonuses are more flexible. This paper introduces a general dynamic contracting framework with flexible incentive pay and moral hazard into the Diamond-Mortensen-Pissarides search model and studies the unemployment dynamics. Labor productivity fluctuations shift firms’ profits and thus affect unemployment dynamics through three channels: 1) production rises directly, 2) wages rise, and 3) workers’ effort endogenously changes due to incentive effects. When contracts are set optimally to incentivize workers, the incentive pay model has identical first order unemployment dynamics to a model with perfectly rigid wages as in Hall (2005) due to an envelope theorem. This result is robust to numerous extensions and suggests that fluctuations in incentive pay are not relevant “wage flexibility” for unemployment fluctuations.

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