Knowledge that Transforms

We develop a dynamic model of learning about worker ability in a competitive labor market. The model produces three testable implications regarding wage dynamics: (1) although the role of schooling in the labor market's inference process declines as performance observations accumulate, the estimated effect of schooling on the level of wages is independent of labor-market experience; (2) timeinvariant variables correlated with ability but unobserved by employers ( such as certain test scores) are increasingly correlated with wages as experience increases; and (3) wage residuals are a martingale. We present evidence from the NLSY that is broadly consistent with the model's predictions.

We develop a framework for quantifying the amount of risk sharing among states in the United States, and construct data that allow us to decompose the cross-sectional variance in gross state product into several components which we refer to as levels of smoothing. We find that 39 percent of shocks to gross state product are smoothed by capital markets, 13 percent are smoothed by the federal government, and 23 percent are smoothed by credit markets. The remaining 25 percent are not smoothed. We also decompose the federal government smoothing into subcategories: taxes, transfers, and grants to states.