Self-Enforcing Labour Contracts and Macroeconomic Dynamics

Article excerpt

Abstract To properly account for the dynamics of the key macroeconomic variables, researchers incorporate various internal propagation mechanisms in their models. In general, these mechanisms implicitly rely on the assumption of a perfect equality between the real wage and the marginal product of labour. This paper features a micro-founded model of a limited-commitment firm, and derive endogenous dynamic labour contracts that produce a different linkage between the real wage and the marginal product of labour. The risk-sharing between the entrepreneur and the worker, both faced with enforcement problems, provides a different type of propagation mechanism. I investigate the dynamic properties of this endogenous rigidity in relation to the initial bargaining power of each agent.

Keywords internal propagation mechanisms * real business cycle * risk-sharing hypothesis

JEL E12 * E49 * J30 * J31 * J41


The motivation of this paper comes from two well-known shortcomings of the macroeconomic literature. On the one hand, some Real Business Cycle (RBC) models have insufficient internal propagation mechanisms. They have difficulties in replicating some key elements of the economy's dynamics. For example, they sometimes fail to completely replicate the observed permanent and transitory characteristics of the impulse-response functions of output, and the observed persistence of output growth (Cogley & Nason, 1995). On the other hand, despite some partially successful attempts, some RBC models also have trouble explaining the aggregate wage dynamics we observe in the data (e.g., the discrepancy between wage and the marginal product of labour, mpl).

In other respects, Beaudry and DiNardo (1995) note that the deviation between the wage and the mpl is at odds with the flexible wage model, but consistent with contracting models. For instance, implicit wage contracts models a la Azariadis (1975), Baily (1974), and Gordon (1974) (ABG hereafter) have already been shown to be relatively effective in generating wage stickiness (Hart & Holmstrom, 1987). This article features a theoretical framework based on this type of contracts. However, the ABG models describe full-commitment allocations; instead, I consider a two-sided limited-commitment economy featuring self-enforcing contracts. These contracts are characterized by an imperfect risk-sharing due to the existence of a limited-commitment problem, where the relationship's continuation is subject to the constraint that no agent is better off taking advantage of an external opportunity. Compared to Thomas and Worral (1988), the paper also provides a numerical computation of contracts specifying the wage and the hours worked, and a study of their implications for macroeconomic dynamics.

The endogenous self-enforcing contracts are used to analyze the implied dynamics of labour and consumption, and to examine to what extent this macroeconomic dynamics differs from the one implied by a flexible wage model. The proposed model generates an endogenous real rigidity coming from the income insurance provided by the risk-sharing hypothesis. It is shown that this rigidity constitutes a promising propagation mechanism. The second section delivers the intuition about using self-enforcing contracts. The third section defines the theoretical framework and provides an explanation of the underlying dynamic bargaining game. The fourth section fully describes the limited-commitment economy. It includes some basic results aiming at characterizing the contracts and the properties of the economy's dynamics. The following section explains the numerical computation of the limited-commitment economy, defines the recursive self-enforcing equilibrium and details some key numerical results. The last section concludes.

Why Rely on the Risk-Sharing Hypothesis?

There are several attractive features associated with the risk-sharing hypothesis. …