Sticky Wages and Prices (Gali Ch 6 - Not in Detail)

Sticky Wages and Prices (Gali Ch 6 - Not in Detail)

ECON 4325Monetary Policy

Lecture 12, spring 2013

Steinar Holden

Rigid wages

-sticky wages and prices (Gali ch 6 - not in detail)

-downward nominal wage rigidity

-monetary policy with large wage setters (Holden – not in detail)Gali Chapter 6 Sticky wages and prices

  • Up till now:
  • Wages taken as given by households and firms
  • Wages flexible so as to clear labor market
  • Marginal product of labor = disutility of labor (i.e. employment at efficient level)
  • Strong evidence that wages are rigid in nominal terms
  • Wages are usually part of a long-term relationship between two parties
  • Wage rigidity may be due to explicit or implicit contract
  • Insurance for risk averse workers
  • Protect return of workers’ investment (avoid “holdup” problem)
  • I.e. not only “distortion”
  • What are the implications of wage rigidity for monetary policy?

Model – builds on Erceg, Henderson, Levin

  • Each household supplies specialized labor services to firms (can also be interpreted as a union organizing all workers of one specific type)
  • Households have some market/monopoly power in the labor market
  • Set wage for their labor type, but high wage leads to lower employment
  • Wage set as markup on MRS (disutility of labor measured in consumption units) => source of inefficiency in steady state; underemployment, not unemployment
  • Markup is lower, the more elastic the labor demand
  • Full consumption risk sharing across households, so income dispersion does not affect other variables.
  • No effect of income distribution
  • Calvo-assumption: Fraction (1-θW) allowed to change wage in every period
  • Otherwise the model as before (consumption and price setting)
  • Optimal allocation will prevail under flexible prices and wages
  • Natural level of output
  • Natural rate of interest
  • Natural real wage
  • Price and wage rigidity leads to distortions
  • Inefficient consumption pattern
  • Inefficient use of different types of labor
  • As before no goods- or labor-type specific shocks => no need to change relative prices or wages
  • Zero price inflation will ensure optimal relative prices
  • Zero wage inflation will ensure optimal relative wages

With rigid prices and flexible wages

  • Zero price inflation prevents distortions in relative prices
  • Wages respond to ensure that real wage is flexible
  • “Divine coincidence” holds in the absence of cost-push shocks: stabilizing price inflation is equivalent to stabilizing the welfare-relevant output gap, i.e. zero price inflation leads to zero output gap.

When both prices and wages are rigid

  • Wages will no longer ensure an optimal real wage, implying that there will be a non-zero output gap even with zero price inflation

=> lead to inefficient fluctuations in average markup of prices over

wages (source of inefficient fluctuations in output)

plus

- inefficient consumption pattern

- inefficient use of different types of labor

=> optimal policy responds to a weighted average of price and wage inflation

=> optimal weight on wage inflation is increasing in wage stickiness

Price inflation function of output gap and real wage gap

Wage inflation function of output gap and real wage gap

Wage gap identity

Dynamic IS equation

Interest rate rule

Note

1)

to the model

2)

Extended Taylor principle

Uniqueness requires (to avoid indeterminacy, assuming Φy = 0)

Both wage and price rigidity

Shock:

  • Exogenous increase in quarterly interest rate of 0.25%;
  • Shock persists with AR(1) coef = 0.5

Evaluation of simple rules

Interaction between wage setting and monetary regime (not in Gali)

Standard view:

  • No long run link between real and nominal variables (classical dichotomy)
  • Short run effects due to nominal rigidities

Two challenges to the standard view:

  • Downward nominal wage rigidity, DNWR
  • Too low inflation leads to excessive unemployment
  • Strategic relationship between monetary policy and large wage setters
  • Strictness of monetary policy may affect the equilibrium rate of unemployment, and the coordination of wage setting

Downward nominal wage rigidity

  • Considerable evidence that wages are rigid downwards in nominal terms

Distribution of individual wage changes

Sources of DNWR

•Fairness

–Survey evidence: nominal wage cuts viewed as unfair even when same real wage cut would be viewed as fair if due to price increase (Shafir et al 1997, Bewley, 1999)

–Experimental evidence Fehr and Tyran (AER, 2001)

Legal/contractualmechanism

–Nominal contracts can only be changed by mutual consent (MacLeod Malcomson, 1993, Holden, 1994)

–Firms must “force” workers/unions to accept wage cut by threats of layoffs, lock-out, closing down plant, etc

These mechanisms are complementary

  • In long run equilibrium, the scope for wage inflation = price inflation + productivity growth
  • If the scope for wage inflation is too small to allow for necessary changes in relative wages, downward nominal wage rigidity may bind and push up wages (increased wage pressure)
  • Workers have ceteris paribus a stronger bargaining position when they resist a nominal wage cut
  • Increased wage pressure leads to higher equilibrium unemployment
  • Highly relevant in the euro-area, where some countries have too high cost level, and need to improve their cost competitiveness

However, DNWR attenuates wage rises at low inflation

  • Employers know that DNWR makes it difficult to cut wages in the future (Elsby, JME 2009)
  • Will attenuate wage increases so ast to reduce risk that DNWR binds in the future
  • Makes inflation more stable when low
  • Reduces risk that e.g. oil price shocks feed into wage increases.
  • Complementary explanation by Blanchard & Riggi (2009): due to less wage indexation and more credible monetary policy

The interaction between the central bank and large wage setters

a) Effect on equilibrium unemployment Bratsiotis and Martin (SJE, 1999), Soskice and Iversen (1998, QJE, 2000)

  • Large wage setters set wages to balance the gain from higher wages against the cost in the form of lower employment
  • A strict monetary regime makes employment more sensitive to the real wage (i.e. higher wages is “more expensive” in terms of lost employment) => wage moderation => lower equilibrium unemployment
  • Norway 2002: High wage growth lead to high interest rate and a strong krone
  • In a monetary union, the interest rate is exogenous for each wage setter.
  • No monetary response deter wage setters,
  • wage pressure and unemployment are higher than under a country-specific inflation target
  • In addition: the Walters’ effect: With a common nominal interest rate, inflation differences are likely to amplify cyclical deviations
  • The boom in Spain and Ireland led to higher wage and price growth, implying a lower real interest rate which strengthened the boom
  • Now, a reduction in wages and prices in the crisis-countries will increase the real interest rate, further depressing demand

b)Effect on the coordination of wage settingHolden (EER, 2005)

  • Theory and evidence suggest that coordination of wage setting leads to considerably lower equilibrium unemployment, without affecting real wages (average finding is 5-6 percentage points lower unemployment!)
  • Why are unions in some countries unable to coordinate on wage restraint?
  • Unions weigh benefits of wage coor. against short run gain by deviating
  • Monetary regime may affect gains from coordination
  • Strict regime disciplines wage setters, making coordination less benef.
  • Coordination may only be sustainable under an accommodating regime (or in a monetary union)


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