Working Paper: CEPR ID: DP2215
Authors: Patrick Minford; Eric Nowell; Bruce Webb
Abstract: 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.
Keywords: monetary targets; base drift; nominal rigidity; indexation of loans
JEL Codes: E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| temporary productivity shocks (J69) | optimal wage contracts are nominal (J41) |
| temporary monetary shocks (E39) | optimal wage contracts are nominal (J41) |
| persistent monetary shocks (E39) | wage indexation increases (J38) |
| persistent monetary shocks (E39) | auction wage shares increase (J39) |
| persistent monetary shocks (E39) | wage protection increases (J38) |
| persistent monetary shocks + persistent productivity shocks (E39) | overall welfare decreases (I30) |