Description:
We consider a labour market with risk averse workers, directed search and asymmetric information in which firms can commit to wage contracts but not to retain workers. The model predicts that in downturns i) firms smooth wages of incumbent workers at a level sufficient to ensure they are not replaced, ii) there is equal treatment of incumbents and new hires, iii) wage smoothing leads to an amplified employment effect, and iv) wages are determined by forecasts of labour market conditions rather than actual values. By contrast in upswings new hire wages are more attuned to actual conditions than forecasts whilst incumbent wages remain relatively rigid. We find that these novel predictions are well supported in German administrative data