Although there is widespread recognition that the impact of monetary and fiscal policies on output, employment and prices may be significantly affected by wage responses to price changes, equilibrium theories of labour markets still require irrational or at least incorrect price expectations to explain such effects. They therefore seem inconsistent with the persistent involuntary unemployment observed in much of Western Europe and Latin America over the last decade. Disequilibrium theories, on the other hand, do not satisfactorily explain either cyclical fluctuations of real wages and employment or nominal wage or price rigidities, so they cannot account for the output and employment effects of monetary and fiscal policy actions.

In Discussion Paper No. 551, Research Fellow Thorvaldur Gylfason and Assar Lindbeck develop a model of wage formation and monetary policy for an economy in which wages are set primarily through collective bargaining between strong and well-coordinated labour unions and relatively weak employers' associations. They apply elements of game theory to a monopoly union model in which a union sets the nominal wage unilaterally. They show that the macroeconomic consequences of monetary policy actions depend ultimately on the preferences of labour and government and also on their perceptions of the structure and functioning of the economy. Their key assumption that unions are concerned about inflation as well as real wages and employment implies that their optimal adjustment of wages to prices severely circumscribes the output and employment effects of monetary policy; and this non-neutral result does not require nominal wage or price rigidities, erroneous or irrational expectations or imperfect foresight.

Gylfason and Lindbeck note that the literature on political business cycles has viewed government policy as responsive to economic developments for some time and argue that the post-war experience of much of Western Europe, Latin America and elsewhere may justify a similar approach to the policies of labour unions. They emphasize labour unions' macroeconomic role including their potential role in perpetuating unemployment and inflation in contrast with several recent game-theoretic approaches in which welfare-maximizing governments confront non-unionized labour. Their model also differs from recent monopoly union models that consider the determination of real wages and employment without including inflation and endogenous government behaviour. Instead, they focus on the sensitivity of output, employment and prices to the strategic interaction between government and organized labour. They show how labour unions optimally adjust wages to prices following changes in monetary policy, how the effectiveness of monetary policy can be circumscribed but not necessarily nullified by unions' optimal reactions, and how the strategic interplay of government and unions may tend to create inflation and unemployment simultaneously.

The Interaction of Monetary Policy and Wages
Thorvaldur Gylfason and Assar Lindbeck

Discussion Paper No. 551, July 1991 (IM)