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This paper explores how the interaction of household heterogeneity and progressive government transfers shapes aggregate labor market fluctuations. Based on the key insights from analytic results in a tractable static model of extensive margin labor supply, we build a dynamic general equilibrium model with both idiosyncratic and aggregate productivity shocks and show that household heterogeneity shapes the dynamics of macroeconomic aggregates substantially when interacted with progressive transfers. Specifically, a notable feature of the performance of our heterogeneous-agent model is its ability to reproduce moderately procyclical average labor productivity while retaining the success of the representative-agent indivisible labor model in generating a large cyclical volatility of aggregate hours relative to output. Using the panel structure of the PSID, we document that, among low-wage workers, (i) the individual-level probability of adjusting labor supply along the extensive margin is significantly higher; and (ii) the fall in employment rate is considerably steeper during the last six recessions, both of which support the key mechanism of our model.
