DP2215 Nominal Contracts and Monetary Targets

Author(s):	Patrick Minford, Eric Nowell, Bruce Webb
Publication Date:	August 1999
Keyword(s):	Base Drift, Indexation of Loans, Monetary Targets, Nominal Rigidity
JEL(s):	E52
Programme Areas:	International Macroeconomics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=2215

We look for a theoretical justification of nominal wage contracts in household diversification of risk. We assume it is more costly for households than for firms to use financial markets for this purpose. In a calibrated general equilibrium model we find from stochastic simulation that if both productivity and monetary shocks are temporary then optimal wage contracts are overwhelmingly nominal. When the dominant shock-usually money - is persistent, wage indexation or the auction wage share (each a form of 'real wage protection') rises sharply. OECD experience in the 1970s fits the model's prediction of high wage protection; for the 1990s the model predicts little reduction in protection. The model suggests that the persistence in monetary shocks- implying that the central bank targets the growth rate rather than the level of the money supply (or the price level), or 'base drift' as currently practised throughout the OECD- not only raises wage protection but also reduces welfare in a world where productivity shocks are persistent, as both theory and our empirical results suggest they are. This suggests that this central bank practice is due for review.