Labour Markets
Nominal Rigidities

A joint CEPR workshop at the University of Aarhus on `Nominal Wage-Price Sluggishness' was held on 28/29 April. The workshop was organized by Torben Andersen (Universiteit van Aarhus and CEPR) and Henri Sneessens (Université Catholique de Louvain and CEPR). It formed part of CEPR's research programme on `Product Market Integration, Labour Market Imperfections and European Competitiveness', supported by the European Commission's Human Capital and Mobility programme.
Steinar Holden (University of Oslo) presented `Wage Bargaining, Holdout and Inflation' examining the consequences of considering `holdout' rather than strike threats. Holdout is a situation where production continues under the terms of the old wage contract while the parties are bargaining. If contracts are set in nominal rather than real terms, workers continue to be paid at their old nominal wage during negotiations. The model also assumes that the workers' union only seeks to maximize the welfare of incumbent workers (insiders) and that outsiders cannot underbid insiders. The bargaining power of each negotiating party is related to its ability to inflict a loss on the other. In this set-up, there is nominal wage rigidity in the sense that the nominal wage of one contract period affects the nominal wages of following periods. In a steady state, the rate of nominal wage growth (inflation) is determined by the bargaining power of the two parties: the stronger the union's relative bargaining power, the higher the steady-state inflation rate. At the aggregate level, this implies a flat Phillips curve: the inflation rate is determined by the negotiation process while employment is determined by real cash balances. When costly outside options are considered (for workers, searching for another job; for firms, firing all incumbent workers and hiring new ones), the flat portion of the curve is reduced to an interval. The left end of the interval corresponds to the full-employment unemployment rate (search costs disappear and the workers' outside option binds); its right end corresponds to the unemployment rate that makes the firm's outside option bind (a high unemployment rate reduces the cost of a lock-out). At these ends, the Phillips curve becomes vertical and the steady-state inflation rate is determined by the money growth.
Jean-Pascal Benassy (CEPREMAP, Paris) developed an extended overlapping generations model to examine the relationships between `Imperfect Competition, Capital Shortages and Unemployment Persistence'. All firms use the same stochastic constant returns to scale production technology. Because firms are price takers on the product and labour markets, the profit-maximizing employment level will always be where the real wage rate is equal to the marginal productivity of labour. Consumers live for two periods: they supply labour inelastically when young, and consume the revenue from first period savings when old. Wages are set by trade unions so as to maximize the expected utility of workers – the real wage bill. Under certain conditions, there is a unique optimal wage rate. This is characterized by a fixed capital-labour ratio, implying some unemployment if the capital stock is too small. Examining the response of capital and employment after an exogenous technological shock, the paper observes that positive and negative shocks have asymmetric effects; and negative shocks may generate unemployment. Even purely transitory negative shocks can produce significant persistence in the unemployment rate, by creating a long lasting `capital gap'.
James Malcomson (University of Southampton) presented a survey `Incomplete Contracts and Labour Markets', asking whether the incomplete contract approach helps to explain labour markets. Fixed wage contracts that are only occasionally renegotiated can be viewed as an optimal arrangement between a firm and its workers when there are significant turnover (hiring and firing) costs and `general' non-worker-specific investment expenditures. This framework helps to explain why nominal wages may respond asymmetrically to shocks, providing a potential micro-theoretic basis for staggered contract models and the apparent slow adjustment of average wages to aggregate shocks. It is also compatible with the observed correlation between the level and variance of inflation and the existence of COLA clauses in wage contracts. In this framework, sticky wages and wages that respond asymmetrically to upward and downward shocks are not synonymous with market failure and inefficient employment levels; they instead represent an efficient response to a well-defined contracting problem, at least as long as the hiring market remains perfectly competitive. In contracting models, the equilibrium wage-employment combinations do not typically correspond to the intersections of standard demand and supply curves. When there are market imperfections, the existence of turnover costs may give rise to inefficiencies even ignoring investment-related issues. When there are opportunities for cooperation and harassment, incentives for inefficient activities can still, under some conditions, be removed by an appropriate choice of contract.
Nils Gottfries (Uppsala University) presented `Nominal Wage Contracts and the Persistent Effects of Monetary Policy', written with Andreas Westermark. The model in this paper combines features of efficiency wage and insider models. It shows that optimal wage contracts may, under some constraints, imply nominal rigidities. Not only do monetary shocks have real effects, but their effects may persist. Because nominal wages are not indexed, an unexpected reduction in money supply reduces output and employment. Because of insider power, employment does not immediately jump back to the previous level when the contract ends. If workers (insiders) have more bargaining power, equilibrium unemployment is higher and demand shocks have more persistent effects. The fact that unanticipated monetary disturbances have real effects creates a credibility problem, which leads to excessive and wasteful equilibrium inflation. The persistence of the effects of the unanticipated shock aggravates the credibility problem. At variance with the standard Barro-Gordon analysis, an increase in equilibrium unemployment, given persistence, reduces equilibrium inflation.
David de la Croix (Université Catholique de Louvain) and Henri Sneessens presented `Skilled Employment Dynamics in an Efficiency Wage Model with Rising Wage Targets'. In their model, firms are assumed to be in a situation of monopolistic competition in the goods market and monopsonistic competition in the skilled labour market. The latter feature indicates that the supply of skilled labour may be relatively scarce (especially in booms), so that firms may find it advantageous to raise their skilled wage rate relative to other firms' to prevent a shortage of skilled labour. The supply of skilled labour to the individual firm is a function of its current wage rate compared to the previous wage rate (`rising wage targets') and other options. The intertemporal optimality conditions are derived and estimated on aggregate French data over the period 1962–91. This modelling approach seems to fit the data fairly well, especially the widening difference between unskilled and skilled unemployment rates and the observed relative wage changes. The long-run implications of the price equation are not rejected, although simple convex price adjustment costs are obviously not capable of explaining the observed nominal rigidities. Simulation results suggest that substantial decreases in the unskilled and the aggregate unemployment rates could be obtained either by decreasing the relative unskilled wage cost (via exemptions to social security contributions) or by decreasing the real interest rate.
In `Wage-price Dynamics and Unemployment Persistence in Switzerland: The Case of a Small Open Economy with a Large Share of Foreign Labour', Peter Stalder (Centre for Economic Research, ETH-Zentrum, Zürich) asked why Swiss unemployment has reached unprecedented levels in recent years, though still at much lower levels than most other European countries. The paper's emphasis is on the role played by migrating foreign workers with the issue framed in an insider-outsider set-up. The key idea is that unions and society care less about employment losses if they affect foreigners who then leave the country: in this context, foreign workers are outsiders, while employed Swiss workers are insiders. But over the last 25 years, the status of foreign workers in the Swiss labour market has changed substantially, as most of them became permanent residents and acquired the same legal status as Swiss citizens. Hence, unemployment can no longer so easily be `exported' during recessions. This change may have affected wage behaviour and the related employment-unemployment dynamics. While in the past, after a sharp fall in employment, recoveries were characterized by persistently low employment levels and rising wage rates because Swiss workers could benefit from insider power and use it to prevent the re-entry of foreign workers, recoveries should now be characterized by higher unemployment persistence and smaller wage increases. These issues are examined in a small but comprehensive macroeconometric model of the Swiss economy, with special attention paid to the cyclicality of the supply of labour, the effect of unemployment on wages and the wage-price spiral.
Jonathan Ireland (University of Strathclyde) and Simon Wren-Lewis (University of Strathclyde and CEPR) examined `Inflation Dynamics in a New Keynesian Model', emphasizing the empirical implications of wage and price equations that embody the effects of nominal rigidities and inflationary pressures on both the goods and the labour market. The wage equation is a weighted average of two kinds of behaviours: staggered wage contracts and traditional spot market wage-setting. Nominal price rigidities are introduced via convex adjustment costs. These two equations are estimated and embedded in an econometric model of the UK economy with rational expectations and including the effect of credit constraints on consumption. It is used to simulate the effects of an unanticipated transitory real disturbance: a 2% increase in real government expenditures sustained for five years. The main conclusions are that allowing for nominal wage rigidities adds nothing to the dynamics of inflation, while nominal price rigidities have a much more significant role; the response of wages to unemployment and of prices to capacity utilization affect significantly the dynamic properties of the model and may well have counteracting effects; and despite the existence of significant nominal price rigidities, the rate of inflation may jump in reaction to an unanticipated real shock.
In `Intertemporal Wage Smoothing', Torben Andersen asked whether New Keynesian models with labour market imperfections fare better than real business cycle models in explaining such stylized facts of the business cycle as the employment variability puzzle (employment highly procyclical but real wages acyclical) and the smaller variability of wages compared to prices. The paper shows how wage inertia can arise, emphasizing the role of credit market imperfections and risk in explaining how and why unions can achieve consumption smoothing via nominal wage smoothing. This is illustrated in a streamlined general equilibrium two-period overlapping-generation set-up, where individual workers supply their labour inelastically when young and consume their savings when old. In every period, the union sets the nominal wage so as to maximize the expected utility of its members over the two periods of their life, given current and expected future prices. When workers have the possibility of saving in an asset bearing a riskless real interest rate, standard results are obtained: nominal shocks have no effects and real shocks have no persistent effects (there is no capital accumulation and no intertemporal labour substitution). The results are quite different if there is no such riskless asset. For example, if money is the sole asset, then the union's optimal nominal wage depends on both the current and the future expected price level. This produces solutions similar to those obtained with staggered nominal wage contracts: nominal as well as real shocks can have lasting effects, nominal wages are less volatile than prices, and employment is procyclical.
Christopher Martin (Queen Mary and Westfield College, London) presented `Inflation, Adjustment and Myopia: Nominal Price Inertia in OECD Countries', a paper which develops and tests a model of nominal price inertia on post-war aggregate data from 19 OECD countries. The highest levels of inertia are found in such countries as Belgium, Germany and the Netherlands; the lowest in Australia, Sweden and the US. Inertia seems to be greater in countries that are more open and which have less inflation and more monopoly power and. There is some evidence that inertia is anti-cyclical. The forward-looking nature of the model also allows testing for myopia: it is rejected in seven of the 19 countries. The estimates of inertia are found to be very sensitive to model specification: simpler representations of price dynamics tend to produce lower estimates of inertia, while simplistic models of the steady-state price produce higher levels of inertia.