Gali Chapter 6 Sticky wages and prices

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1 Gali Chapter 6 Sticky wages and prices Up till now: o Wages taken as given by households and firms o Wages flexible so as to clear labor market o Marginal product of labor = disutility of labor (i.e. employment at efficient level) Strong evidence that wages are rigid in nominal terms Wages are usually part of a long-term relationship between two parties o Wage rigidity may be due to explicit or implicit contract o Insurance for risk averse workers o Protect return of workers investment What are the implications of wage rigidity for monetary policy? 1

2 Model builds on Erceg, Henderson, Levin Each household supplies specialized labor services to firms (can also be interpreted as a union organizing all workers of one specific type) Households have some market/monopoly power in the labor market o Can set wage rate for their labor type, but high wage leads to lower employment o Wage set as markup on MRS (disutility of labor measured in consumption units) => source of inefficiency in steady state; underemployment, not unemployment o Markup is lower, the more elastic the labor demand Full consumption risk sharing across households, so income dispersion does not affect other variables. o No effect of income distribution Calvo-assumption: Fraction (1-θ W ) allowed to change wage in every period 2

3 No labor-type specific shocks => no need to change relative wages o Zero wage inflation is optimal If wages are rigid, and wage inflation differs from zero, then relative wages will be distorted, leading to inefficient use of different types of labor (source of ineff. fluctuations) As before: If prices are rigid, and price inflation differs from zero, then relative prices will be distorted, leading to an inefficient consumption pattern 3

4 Price inflation function of output gap and real wage gap Wage inflation function of output gap and real wage gap Wage gap identity ω ω + π π ω w p n t t 1 t t t Dynamic IS equation Interest rate rule Note Uniqueness requires (extended Taylor principle) 4

5 Both wage and price rigidity => lead to inefficient fluctuations in average markup of prices over wages (source of inefficient fluctuations) => optimal policy responds to a weighted average of price and wage inflation => optimal weight on wage inflation is increasing in wage stickiness With only price rigidity => divine coincidence holds: stabilizing price inflation is equivalent to stabilizing the welfarerelevant output gap, i.e. zero price inflation leads to zero output gap (except when there are costpush shocks) When wages are also rigid, zero price inflation will involve distortion of the real wage, and thus also involve a non-zero output gap 5

6 Shock: Exogenous increase in quarterly interest rate of 0.25%; Shock persists with AR coef = 0.5 6

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9 Evaluation of simple rules Strict rules: zero wage/price/composite inflation Flexible rules: Interest respond to inflation target (wage/price/composite) Loss measured in percent of steady state consumption Sticky wages => important to stabilize wage inflation 9

10 Downward nominal wage rigidity (not in Gali) Considerable evidence that wages are rigid downwards in nominal terms o Wage cuts considered as unfair o Nominal wage cut requires mutual agreement In long run equilibrium, the scope for wage inflation = price inflation + productivity growth If the scope for wage inflation is too small to allow for necessary changes in relative wages, downward nominal wage rigidity may bind and push up wages (increased wage pressure) Increased wage pressure leads to higher equilibrium unemployment Highly relevant in the euro-area, where some countries have too high cost level, and need to improve their cost competitiveness 10

11 The standard model with no DNWR Real wage Wage curve Price curve N* Employment N Steady-state inflation has no effect on eq. employment Steinar Holden 8 11

12 DNWR and low steady-state inflation Real wage Wage curve, no inflation Wage curve, high inflation Price curve N L N H Employment N Steinar Holden 12

13 Inflation The long run Phillips-curve U L U H Unemployment Steinar Holden 13