Working Paper: NBER ID: w2152
Authors: Joshua Aizenman
Abstract: This paper explains prices, output and employment adjustment In an open economy characterized by a monopolistic competitive market structure where goods prices are flexible while wages are determined by contracts that pre-set the wage path for several periods. The paper solves the rational expectation equilibrium in an economy characterized by staggered, unsynchronized wage negotiation, for which the degree of contract staggering IS endogenously determined. It investigates the adjustment of output, exchange rate and prices to nominal and real shocks, and to what extent that adjustment depends on the market power enjoyed by each producer and the substitutability between domestic and foreign goods. It also studies the potential role of indexation clauses, like wage indexation to nominal income. The analysis shows that unexpected monetary shocks can generate persistent aggregate output and relative price shocks, whose nature is determined by the degree of substitutability between domestic and foreign goods. Greater substitutability induces a greater output and employment effects and smaller prices effects in the short and the Intermediate run. On the other hand, greater substitutability is shown to reduce the persistency and duration of the adjustment. If the income elasticity of the demand for money is less than unity the presence of nominal wage contracts tends to magnify the responsiveness of the economy to real shocks, and a larger degree of substitutability will magnify the short-run and the intermediate-run adjustment of prices and output to real shocks, and will reduce the needed adjustment of relative prices.
Keywords: Monopolistic competition; Labor market adjustment; Nominal shocks; Real shocks; Wage contracts
JEL Codes: E24; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| unexpected monetary shocks (E39) | persistent aggregate output shocks (E32) |
| unexpected monetary shocks (E39) | relative price shocks (P22) |
| degree of substitutability between domestic and foreign goods (F49) | nature of shocks (E32) |
| greater substitutability (D11) | larger output effects (E23) |
| greater substitutability (D11) | larger employment effects (J68) |
| greater substitutability (D11) | smaller price effects (D41) |
| income elasticity of demand for money < 1 (E41) | nominal wage contracts magnify responsiveness to real shocks (J39) |
| nominal wage contracts magnify responsiveness to real shocks (J39) | significant adjustments in prices (P22) |
| nominal wage contracts magnify responsiveness to real shocks (J39) | significant adjustments in output (E23) |
| larger degree of substitutability (L15) | magnifies short-run adjustments (F32) |
| larger degree of substitutability (L15) | reduces necessary adjustments of relative prices (F16) |
| speed of adjustment (F32) | accelerates during adjustment process (F32) |
| speed of adjustment (F32) | differs from linear models (C32) |
| dynamics of adjustment (F32) | characterized by interplay between wage rigidity and substitutability of goods (F16) |
| dynamics of adjustment (F32) | implications for labor market guidelines (J48) |