Underlying the Keynesian approach to macroeconomics is the assumption of inefficiencies or, as they are sometimes called, frictions. The precise sort of friction to be introduced into the model, however, is controversial. A traditional friction uses sticky nominal wages.(1) One common explanation for sticky nominal wages is labor-market contracts, that is, contracts that fix the nominal wage workers receive and then allow firms to determine the level of employment.(2) Fischer , Phelps and Taylor , and Taylor  present typical models, which assume that contracts make nominal wages rigid to some degree and that the level of employment is adjusted in accord with the firm's labor demand schedule. Nominal wage contracts also are common when developing the textbook IS-LM and AD-AS models. At the professional level, Fischer  has argued strongly in favor of the IS-LM model and Gali  suggests that this model fits the postwar U.S. experience reasonably well.
The standard view of the effects from nominal wage contracts has been challenged. Barro  pointed out that even though a labor contract may fix the nominal wage, firms and workers can equate the marginal product of labor to the marginal value of workers' time over all states of nature and thus jointly insure that employment does not deviate from its efficient, auction market level. Hall  extended Barro's insight by arguing that labor relationships are long tenn so that each side has an incentive to deal fairly with the other by not taking advantage of changes in the price level. Essentially, Barro and Hall show that a contract allowing employment to be determined solely by a firm's labor demand curve is inefficient. Indeed, the Barro/Hall conclusion that fixed nominal wages may co-exist with efficient levels of labor employment is an important justification for the implicit assumption in most real business cycle models that employment is determined in an auction-like labor market.
Some economists, such as Ahmed , Card , and Keane  have directly studied the importance of labor contracts. The results from these papers are mixed. Ahmed investigates the importance of contracts that fix the nominal wage by testing whether the responses of employment and output to changes in the money supply are sensitive to the degree of wage indexation. The basic idea is that if nominal wage contracting matters, the less flexible (that is, the less indexed) is the wage, the greater the impact of a monetary shock on employment and output. Using Canadian manufacturing industries, which employ a variety of indexing schemes, Ahmed fails to find any relationship between the degree of contracting and the extent to which a monetary shock affects real variables. Keane uses data on individuals from the National Longitudinal Survey of Young Men to study the response of real wages to unanticipated inflation and monetary growth. To the extent that contracts fix the nominal wage workers are paid, unexpectedly higher inflation should lower the real wage. Keane, however, finds no evidence in support of this proposition. Finally Card, who also used Canadian data, asserts that it is the unexpected fall in the real wage (namely unanticipated price rises), along with the degree of indexation, that should generate positive employment responses.(3) He thus constructs measures of unexpected inflation and real wage changes. Contrary to Ahmed and Keane, Card's results support a role for surprise inflation in raising employment levels via end-of-contract real wage levels. Card concludes that nominal contracts are instrumental in determining labor and output reactions.
In this paper we follow Ahmed, Card, and Keane by providing some additional evidence on the real effects from nominal wage contracting. We use Brazilian data and exploit the fact that Brazilian firms were required by law to adjust workers' salaries at specified intervals to keep pace with inflation, which was very high, and productivity. …