Nominal Wage Contracts and the Monetary Transmission Mechanism

By Janko, Zuzana | Economic Inquiry, January 2007 | Go to article overview

Nominal Wage Contracts and the Monetary Transmission Mechanism


Janko, Zuzana, Economic Inquiry


I. INTRODUCTION

In their papers, Kydland and Prescott (1982) and Long and Plosser (1983) show that a one-sector real business cycle model, subject to technology shocks, closely matches the business cycle properties of real variables to those found in postwar U.S. data. However, as found by Cooley and Hansen (1989), in order to match the business cycle properties of nominal variables, a propagation mechanism for monetary shocks is needed. Subsequent work by Cho (1993), Cho and Cooley (1995), Cho, Cooley, and Phaneuf (1997), etc., indicates that incorporating nominal rigidity can solve the propagation problem. In this paper, we analyze the monetary transmission mechanism introduced in these papers--synchronized wage setting as well as staggered wage setting. While empirical evidence suggests the use of staggered wage setting in modeling the U.S. economy as compared to the synchronized setting, we nevertheless explore the latter to better understand the monetary propagation mechanism created by nominal wage rigidity. (1)

In a model with synchronized wage contracting, all agents agree to set a nominal wage for j successive periods simultaneously. In contrast, under staggering, at any given time period, there is a fraction of agents setting a nominal wage for j consecutive periods, where this fraction is 1/j. Irrespective of contract type, when the nominal wage is agreed to, households cede to the firm the right to determine labor hours. Once the nominal wage is adopted, households supply labor hours as determined by the firm. Except for the different wage contract formulations, our assumptions are identical across both models.

We find the economy with nominal wage contracts to be much more volatile than the economy without wage contracts. Specifically, the volatility of real variables rises sharply when nominal wage rigidity is introduced. However, nominal wage contracts do help in matching the volatility of nominal variables as compared to a model without contracts. In addition, we find that the correlation between output and inflation and interest rate is improved upon in a model with contracts. However, nominal wage contracts fail in matching the correlation of output with productivity as well as in improving persistence. Overall, a comparison between contract types shows that the monetary transmission mechanism generated via staggered contracting does better in matching the U.S. data.

Our impulse response functions reinforce the statistical findings. The impact of monetary shocks is strongest given a synchronized nominal wage setting. Lastly, we obtain welfare costs of contracts measured in terms of consumption. (2) We find that welfare costs are slightly higher under synchronized contracting as compared to staggered. Hence, in terms of welfare, staggered contracts are more desirable.

The remainder of this paper is organized as follows: Section II gives the features of the economy while Section Ill discusses the two contract types and shows how labor hours are determined in each economy. In Section IV, we define the recursive competitive equilibrium and discuss the solution method used to solve the dynamic programming problem. The model is calibrated in Section V. We present our simulation results, which include standard deviations, correlations, impulse response function, and welfare costs, in Section VI. Section VII concludes the paper.

II. THE ECONOMY

Firms

Firms produce output using a Cobb-Douglas production function:

(1) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII],

where Y, K, and H are aggregate output, capital stock, and labor, respectively. (3) The parameter [alpha] represents capital's share in total income. The production function exhibits constant returns to scale; thus, it can be assumed, without loss of generality, that there is only one competitive firm. The production function is subject to a technology shock [z. …

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