In most euro area countries labor unions and collective bargaining (1) play an important role in determining labor market dynamics. It is often argued that centralized union bargaining amplifies inefficient unemployment dynamics, since bargained wages are distorted by the presence of union rents and firms choose labor demand ex post, therefore exposing employment to shock fluctuations. (2) The presence of inefficient unemployment dynamics calls for active monetary policies. In this paper, we take a public finance approach to analyze the design of optimal monetary policy: in presence of union rents, inflation can indeed be used as a means of indirect redistribution between current employed union members and unemployed workers with the goal of bringing unemployment closer to the constrained pareto efficient level.
Our benchmark model includes price rigidities and unionized labor markets. The assumption of price rigidity allows us to account for a direct link between unemployment and inflation. Workers' unionization implies that the labor market is non-Walrasian and that wages are set as a mark-up over their reservation value. The presence of a wage mark-up produces a wedge in the labor market equilibrium conditions, which induces inefficient unemployment fluctuations. Unions set wages by maximizing a weighted average of the workers' aggregate surplus from the job and aggregate employment. (3) Workers' surplus from the job is given by the difference between the aggregate wage and the reservation wage, which represents unions' threat point, namely the wage process below which workers would not enter negotiations. Based on a worker participation constraint the reservation wage is set equal to workers' outside option, given by a weighted average of the unemployment benefit and the wage prevailing on a nonunionized labor market. As the unemployment benefit is determined based on past wages, in equilibrium unionized wages are also characterized by history dependence. This assumption allows to introduce real-wage rigidity into the model in a tractable way and consistently with evidence in Blanchard and Katz (1999) and Ball and Moffitt (2001). (4) Negotiations take the form of a right to manage bargaining: after wages are set collectively, individual firms determine employment along the labor demand schedule. (5) In this context, the labor market equilibrium is obtained as solution to a Stackelberg game between the union and the firm; this implies that neither of the two internalize the effects of wage settings on employment dynamics. Indeed, since firms take wages as given, they react to shocks by adjusting the employment margin ex post. Under such a mechanism employment becomes the main shock absorber, therefore deviating from the Pareto efficient reference.
The design of optimal policy is done in two steps. First, the optimal path of variables is characterized by following a Ramsey approach. (6) This approach allows us to study optimal policy in economies that evolve around a distorted steady state and by relying on public finance principles. Specifically, the Ramsey planner maximizes household welfare subject to the constraints describing the equilibrium in the private sector economy, and via an explicit consideration of all the distortions that characterize both the long-run and the cyclical behavior of the economy. A novel aspect, related to the use of a public finance approach, stems from the fact that, to the extent that deviations from the flexible price allocation occur, positive volatility of inflation can be interpreted as a tax on labor union rents. State contingent movements in inflation become welfare improving as they acquire a redistributive role between employed union members and unemployed workers. Second, an optimal rule is obtained by maximizing agents' conditional welfare. Crucial in our analysis and in the evaluation of welfare is the use of second-order approximation of the full competitive equilibrium relations and of the agents' utility. …