Empirica (2013) 40:215–235 DOI 10.1007/s10663-012-9183-x ORIGINAL PAPER

Trend inflation as a workers’ discipline device Giovanni Di Bartolomeo • Patrizio Tirelli Nicola Acocella

•

Published online: 17 February 2012 Ó Springer Science+Business Media, LLC. 2012

Abstract The paper shows that a monetary policy regime that allows for a positive inflation rate disciplines monopolistic wages setters if these, when setting contracts, internalize the consequences of their choices for economic outcomes over the life of the contract. We also show that discretionary monetary policy has real effects when wage setters are non atomistic, whereas commitment to a positive inflation rate is effective irrespective of the degree of labor market centralization. Finally, the model may explain the different unemployment dynamics in Europe and in the United States, following the 1980 disinflationary episode. Our approach suggests that disinflation induced an adverse effect on the labor market wedge and that such effect was stronger in Europe, due to the particular importance of large wage setters. Keywords Inflation bias  Discretionary monetary policy  Non-zero inflation targeting  Unemployment  Strategic wage setters JEL Classification

E52  E58  J51  E24

G. Di Bartolomeo University of Teramo, Teramo, Italy e-mail: [email protected] P. Tirelli University of Milan Bicocca, Milan, Italy e-mail: [email protected] N. Acocella (&) Sapienza University of Rome, Rome, Italy e-mail: [email protected]

123

216

Empirica (2013) 40:215–235

1 Introduction Is there a long-run (permanent) trade off between price stability and output and employment? According to the conventional wisdom, inflation has adverse effects due to relative price dispersion and to the effect of expectations on mark-ups (Goodfriend and King 1997; Woodford 2003; Schmitt-Grohe´ and Uribe 2004). Other contributions point in the opposite direction. Benigno and Ricci (2010) resurrect the ‘‘grease in the wheels’’ argument, showing that downward nominal wage rigidity generates a long-run inflation-unemployment trade-off at low inflation rates. In Graham and Snower (2008) the interaction of staggered nominal contracts with hyperbolic discounting leads to a positive long-run effect of inflation on real variables. We share the view that modern macromodels underestimate the beneficial effects of inflation on wage markups in the long run, but we highlight a new, different incentive mechanism. Three key elements characterize our model. First, inflation acts as a tax on money balances by raising the opportunity cost of holding money and therefore reduces households welfare (see Canova and Meinz 2011). Second, wage setters internalize the effect of their wage choice on real money holdings, which—in turn—is driven by the central bank choice of the inflation rate. This strategic interaction between the wage setters and the central bank is the crucial innovation of the paper. In fact, recent micro-level evidence on wage bargaining shows that wage renegotiations take place while expiring contracts are still in place (Du Caju et al. 2008), enabling wage setters to internalize the consequences of their decisions over the life of the next contract. This central feature is typically neglected in the standard New Keynesian approach where wage dynamics are modeled as a mechanical transposition of the formalism designed to capture price staggering (Erceg et al. 2000). More formally, we assume that wages are pre-determined. This implies that in our model wage setters act as Stackelberg leaders, whereas in the standard New Keynesian model the wage-setting rule implies that they play a Nash game. The third distinctive feature of our approach is that the model accounts for both the relatively ‘‘large’’ trade unions typically associated to continental Europe and the atomistic wage setters popularized in New Keynesian models, which are more suitable for the analysis of Anglo-Saxon labor markets (see Schmitt-Grohe´ and Uribe 2007: 4). We investigate two monetary policy regimes: discretion and commitment to a positive inflation rate. In the past, even leading central banks such as the Federal Reserve and the Bundesbank chose to implement discretionary monetary policies (Mishkin and Posen 1997; Ireland 1999). More recently, commitment to a positive long-run inflation target has become a widespread Central Bank practice. Our model has several implications concerning wage setting behavior, unemployment dynamics and central bank policies. First, we find that inflation disciplines wage setters under both discretion and commitment, but for different reasons. Under discretion, the wage markup is moderated by unions’ anticipation of the central bank’s reaction and thus is inversely related to the number of unions. Under commitment the disciplining effect of inflation obtains irrespective of the degree of labor market centralization, and is determined by the complementarity between inflation and wage increases in

123

Empirica (2013) 40:215–235

217

determining the marginal utility of expected real money holdings. Second, calibrations show that monetary discretion may have non-negligible effects on unemployment even when the number of wage setters is relatively high. Thus our analysis of discretionary inflation equilibria may be relevant beyond the boundaries of continental Europe. Third, discretionary monetary policy has substantial disciplining effect on wage setters irrespective of the weight real money balances have in the utility function. Thus the widely popular practice of neglecting money balances when considering policy analysis is misleading if wages are predetermined. Fourth, the mechanism highlighted in the paper may explain the different unemployment dynamics in Europe and in the United States, following the 1980 disinflationary episode. In fact our approach suggests that disinflation induced an adverse effect on the labor market wedge and that such effect was stronger in Europe, due to the particular importance of large wage setters. Our work is related to (and substantially different from) early contributions, often not micro-founded, which show that the discretionary monetary policy regime affects real variables when the labor market is relatively centralized.1 This result mainly depends on the existence of nominal wage externalities among the labor unions (see Acocella et al. 2008). We investigate a different source of non neutrality, originating from a non-trivial role of real money holdings. In addition, we show that such non-neutrality is observed even when wage setters are atomistic. Other attempts to reconsider monetary policy games within a general equilibrium framework (Neiss 1999) completely overlook the issue because they assume a perfectly competitive labor market. Gnocchi (2009) extends an otherwise standard New Keynesian model to allow for the presence of large wage setters. Unlike this paper, he assumes away the effects of long-run inflation and focuses on the effects of reducing inflation volatility in response to shocks. The rest of the paper is structured as follows. Section 2 describes the model. Section 3 provides a discussion of the key mechanism driving our results. Section 4 computes the model solution under discretionary monetary policy. Section 5 considers monetary pre-commitment. Section 6 concludes.

2 The model We build on Neiss (1999) model, where a staggered timing structure in the acquisition of nominal money balances within a money-in-the-utility-function framework generates a discretionary inflation equilibrium when the economy is characterized by monopolistic distortions in the goods market and nominal wages are pre-determined. We extend Neiss’ model by introducing a monopolistic structure in the labor market and allow for different degrees of labor market centralization. This allows to investigate the real long-run effects of alternative monetary policy regimes. Right from the outset, it should be noted that we do not model shocks and business cycle dynamics. The motivation for this choice is twofold. First, by limiting the 1

See e.g. Soskice and Iversen (1998, 2000), Bratsiotis and Martin (1999), Cukierman and Lippi (1999), Guzzo and Velasco (1999), Lippi (2003), Holden (2005), Cukierman (2004), Coricelli et al. (2006).

123

218

Empirica (2013) 40:215–235

complexity of the model we sharpen the focus on the monetary policy games considered in the paper. Second, our aim here is to characterize the long run effects of the monetary regime choice, which hold irrespective of short-run dynamics. The task of integrating the wage disciplining effects determined by the choice of the monetary policy regime into a fully-fledged business cycle model goes beyond the objective of the present paper.

3 Households The representative household (i) maximizes the following utility function  1e ! 1 X g 1þ/ c Mt;i t U¼ lt;i þ b lnðct;i Þ  1 þ / 1  e Pt t¼0

ð1Þ

where b 2 ð0; 1Þ is the intertemporal discount rate, ct,i is a consumption bundle, lt,i M is a differentiated labor type that is supplied to all firms, Pt;it denotes real money 2 holdings. The flow budget constraint is: ct;i þ

Mtþ1;i Btþ1;i Wt;i Mt;i st Bt;i þ ¼ lt;i þ þ þ ht þ Rt Pt;i Pt Pt Pt Pt Pt

ð2Þ

where Bt,i denotes holdings of one-period bonds purchased in t - 1; Wt,i is the nominal wage; st is a lump-sum transfer from central bank profits, ht denotes firms profits, Rt is the nominal interest rate.3 Note that Mt?1,i is chosen at t. Consumption basket and price index are defined as follows: 0 1 1q1 Z ct ¼ @ ct ðjÞq djA ð3Þ 0

0 Pt ¼ @

Z1

1q1 q q

pt ðjÞq1 djA

ð4Þ

0

The standard first order conditions for consumption are:4  1 Pt ðjÞ q1 ct ðjÞ ¼ ct Pt

ð5Þ

2

New Keynesian models typically assume logarithmic preferences over real money balances (Corsetti and Pesenti 2001). Here we assume e [ 1 , which is sufficient to ensure that the marginal cost to inflating is positive in discretionary inflation and that the solution to the monetary authority problem in the game with the wage setters is always a global maximum (see Neiss 1999: 361, 368). B

3 The term Rt Pt;it defines interest service payments on bonds purchased at time t - 1. These are real payments as they are defined in terms of the consumption price level. 4

Index i is dropped for simplicity.

123

Empirica (2013) 40:215–235

219

kt ¼ kt ¼ b

1 ct

ð6Þ

Rtþ1 ktþ1 ptþ1

where Pet?1 denotes the expectation for next period price level. The money demand equation is  1e  1e e Mtþ1 Pt cb ¼ Pt Petþ1 ð1  R1 tþ1 Þkt

ð7Þ

ð8Þ

As in Neiss (1999) the agent faces a trade-off between period t consumption and period t ? 1 holdings of nominal money balances. Observe that (8) can also be interpreted as a demand function: when the central bank increases next period nominal money balances, coeteris paribus current consumption increases. The condition about the optimal labor supply will be introduced at a later stage, when we consider different wage-setting regimes. 3.1 Firms There is a continuum of monopolistically competitive firms uniformly distributed over the interval [0,1]. Each firm (j) produces a differentiated good using a CobbDouglas production function:5 yt ðjÞ ¼ lt ðjÞa

ð9Þ

where 2 lt;j ¼ 4

Z1

r 3r1 r1 r

lt;j ðiÞ di5

ð10Þ

0

denotes a labor bundle and r is the intra-temporal elasticity of substitution across different labor inputs. For any given level of its labor demand, lt,j, the firm must decide the optimal allocation across labor inputs, subject to aggregation technology (10). Firm (j) demand for labor type (i) is   Wt ðiÞ r lt;j ðiÞ ¼ lt;j ð11Þ Wt where 1 2 1 31r Z Wt ¼ 4 wt ðiÞ1r di5

ð12Þ

0

Aggregating across firms we obtain 5

Capital is assumed fixed and normalized to unity.

123

220

Empirica (2013) 40:215–235

Yt ¼ Ct ¼ lat   wt ðiÞ r lt ðiÞ ¼ lt wt   1 1 wt 1a lt ¼ aq pt

ð13Þ ð14Þ ð15Þ

3.2 Labor market The economy is populated by n unions. Workers equally split across unions (each union has mass n-1). The mass can be interpreted as the degree of wage setting centralization as well as unions’ ability to internalize the consequences of their actions (unions’ coordination). Following Gnocchi (2009), we assume that each union maximizes members’ lifetime utility (1) subject to the budget constraint (2) and to labor demand for all union’s members. We also assume that each union bargains over the real wage taking other unions’ decisions as given. Each union understands that a wage increase will trigger two adverse effects: a substitution effect, due to the relative wage change, and an aggregate labor demand effect, due to the increase in the aggregate real wage. In fact, by deriving and integrating (12), in the decentralized equilibrium each union (z) anticipates that6  r owt 1 wt ðzÞ ¼n ð16Þ wt owt ðzÞ 3.3 Monetary policy At time t the central bank sets next period money supply (Mt?1): Mtþ1 ¼ Mt ð1 þ mt Þ

ð17Þ

We therefore treat mt as the central bank control variable. As in Neiss (1999) choosing mt is equivalent to setting the inflation rate. In the following we consider two policy regimes. In the first (discretionary) regime the central bank maximizes  1e ! 1 X g c Mt;i 1þ/ lt;i þ B UB ¼ bt ln Ct;i  ð18Þ 1 þ / 1  e Pt t¼0 taking wages as given. In traditional time-inconsistency models, the central bank’s aversion to inflation crucially affects the outcome of monetary policy games under discretion. To capture this effect we differentiate between: (a) cB = c, which denotes the standard case of 6

In the literature it is sometimes assumed that unions bargain over the nominal wage. In that case the union takes as given the nominal wage set by the other unions. Our choice is justified here because the focus of the paper is on the strategic interaction between unions and the monetary authority, via the real money balances effect. The well-known effects of monetary policy on nominal wage externalities and unions’ interactions are discussed in Lippi (2003), Coricelli et al. (2006) or Acocella et al. (2008).

123

Empirica (2013) 40:215–235

221

discretion , where the central bank shares the representative household’s preferences; (b) cB = c, the case of distorted preferences, which allows to replicate both Rogoff’s (1985) inflation-conservative central banker (cB [ c) and Guzzo and Velasco’s (1999) populist central banker (cB \ c). The second regime we consider is commitment to an exogenous money growth rate, m*. In our framework this is equivalent to choosing an inflation target (Svensson 1997).

4 Flexible versus pre-determined wages: the disciplining role of expected inflation In this section we discuss how nominal wage rigidity affects wage-setting behavior, and highlight the key mechanism behind the disciplining effect of inflation. To begin with, consider the case of flexible wages, when each union (z) maximizes (1), taking real money balances as given and subject to the budget constraint (2), (14), (15). The trade union first order condition is7     a 1 lt ðr  1Þðn  1Þ  1a l1þ/ rðn  1Þ þ 1a t 0¼ þg ð19Þ t Ct w This implies that t ¼ gll/t Ct w

ð20Þ

where: l¼

rðn  1Þ þ ð1  aÞ1 ðr  1Þðn  1Þ þ að1  aÞ1

ð21Þ

denotes the wage mark-up under flexible wages. Observe that (21) is consistent with alternative labor market regimes, ranging from perfect competition (n, r ! 1, l = 1). to monopolistic competition (n ! 1, 1\r\1, l = r(r 1)-1), to strategic wage setting ð1  n\1; 1\r\1Þ. Using (15) and the goods market clearing condition Ct = Yt equilibrium employment is: 1  1þ/ aq ll ¼ ð22Þ gl Observe that lq-1 denotes the labor and goods market wedge. The competitive (Pareto optimal) level of employment obtains if lq-1 = 1. Since output and consumption are time-invariant, from (7) the nominal interest rate is Rtþ1 ¼ 7

1 Petþ1 b Pt

ð23Þ

Subscripts z have been dropped since the symmetric equilibrium has been imposed.

123

222

Empirica (2013) 40:215–235

where expected inflation is obviously determined by the monetary policy stance. Neiss (1999) has shown that under discretion monetary policy is time invariant:8 Petþ1 ¼1þm Pt

ð24Þ

Plugging (17), (23), (24) into (8) we get the equilibrium level of real money balances:  1e Mt cbCt ¼ ð25Þ Pt 1þmb Consider now the case of predetermined wages when unions must choose the nominal wage rate conditional to their expectations about price, consumption, production and monetary policy decisions.9 Results are driven by the wage setters’ expected impact of their choices on (25). More specifically, wage setters are disciplined to the extent that a wage increase raises the marginal utility of real money holdings. In the following, we will show that this disciplining effect is positively related to the expectation of m that, by raising the expected marginal utility of money holdings, induces wage setters to moderate wage claims in order to lower expected prices and to dampen the expected fall in real money holdings.

5 Discretionary monetary policy The timing of the game is as follows. (1) Before the price level is known, trade et Pet , where w et is the desired real unions must choose the nominal wage rate, wt ¼ w wage rate. (2) The central bank chooses its monetary policy. Then, full price flexibility ensures that markets clear. The model is solved by backward induction. 5.1 Derivation of the wage markup The central bank maximizes (1) with respect to mt, taking wages as given.10 This is equivalent to assuming that inflation is the control variable. For expositional purposes we define the ex post real wage, employment and consumption as functions of inflation surprises  e Pe wt w ð1 þ pet Þ et ¼ t t ¼w ð1 þ pt Þ Pt Pt  e  1 t 1 þ pet 1a w lt ¼ aq 1 þ pt

8

A fortiori under precommitment this results to a constant money growth rate.

9

This modeling strategy is used in Neiss (1999).

10

ð26Þ ð27Þ

In this model there is no state variable to link periods and the policy problem is time invariant; see Neiss (1999) for a discussion. We closely follow her solution method.

123

Empirica (2013) 40:215–235

223

 Ct ¼ Yt ¼

1 e 1 þ pet  w aq t 1 þ pt

a 1a

ð28Þ

Pe P

t1 where pt ¼ PtPP and pet ¼ t Pt1t1 denote the inflation rate and its expectation, t1 respectively. wt ð1aÞ Bearing in mind that pt ¼ aq lt , the central bank’s first order condition is:  1e a g 1þ/ Mt  l c ¼0 ð29Þ 1a 1a t Pt

Condition (29) identifies the marginal costs and benefits of an expansionary monetary policy. By raising next period money supply, Mt?1, the central bank aims at an increase in current consumption at the cost of raising the disutility from labor effort and of reducing current real money balances, due to the surge in inflation. Substituting (29) into (25) and imposing rational expectations11 we obtain the central bank inflation response: 1  e1 e h a ie1 1 g e e  ðlet Þ1þ/ bCte mt ¼ pt ¼ b  1 þ ð30Þ c 1a 1a et , i.e. the real wage that The trade union problem is solved by choosing w maximizes the expected value of (1) subject to (16), (26), (27), (28), (25) and (30).12 Imposing the symmetrical equilibrium, the first order condition is     a 1 let ðr  1Þðn  1Þ þ 1a ðlet Þ1þ/ rðn  1Þ þ 1a d ¼g ð31Þ et w Cte where d¼

1þ/ ð1  aÞðe  1Þ

denotes the trade unions’ anticipation of the central bank’s reaction to their wage choices. In fact, the higher the real wage, the lower the level of employment, the more the central bank is willing to inflate, reducing equilibrium real money balances. Equation (31) implies that et ¼ gled ðlet Þ/ Cte w

ð32Þ

where led ¼ l 

d a ðr  1Þðn  1Þ þ 1a

ð33Þ

11 Note that the wage-disciplining mechanism discussed here does not require any sort of money illusion or the inability of price setters to choose the desired mark up. In fact in the model there are no monetary surprises and the results would obtain even if we assumed that wage contracts are defined as a full indexation clause with respect to the bargained real wage. 12 In alternative to the direct substitution of (29) in (1) one might obtain from (25) and (29) the central bank inflation response to wage setting decisions.

123

224

Empirica (2013) 40:215–235

Fig. 1 Markups and non atomistic wage setters 1

rðn1Þþð1aÞ l ¼ ðr1Þðn1Þþað1aÞ 1 Monetary policy is non-neutral because the wage setters

anticipate the inflationary response of the central bank to their wage choice. The combination of wage stickiness, concern for real money balances and discretionary monetary policy can discipline wage setters. This result holds for any positive— even small—value of real money balances in the utility function. Thus, the widely popular practice of neglecting real money balances is misleading when wage setters are non atomistic. Indeed, the moderating effects of discretionary monetary policy are inversely related to the number of wage setters. In fact, the wage markup (33) grows r monotonically with n and for n ! 1 the atomistic markup r1 is obtained, but nonnegligible effects can be detected also for large values of n, as shown in Fig. 1.13 We can now characterize equilibrium employment and inflation. The solution for equilibrium employment is: 1  1þ/ aq ld ¼ [ ll ð34Þ gled Substituting (13), (34) into the central bank’s first order condition (30) we get:

13

In the figure we plot the markup for some of the different values of r normally used in the literature. a is set at 0.6. Observe that, for the parameterization used in Fig. 1 the flexible wage markup, l, falls with the number of unions. When wages are predetermined, this effect is entirely reversed under monetary policy discretion.

123

Empirica (2013) 40:215–235

225

1   e1   e 1 a q e1 a 1 e p¼b1þ bld c 1a ld |fflfflffl{zfflfflffl}

ð35Þ

Bias

Equation (35) clearly shows the inflation bias emerging from discretion. 5.2 A quantitative assessment In order to illustrate our findings, namely the disciplining role of discretion vis-a`-vis the flexible wage regime, we consider a numerical exercise referred to two economies where a different number of ‘‘large’’ unions operates. For the sake of exposition we refer to the United States and Europe over the period 1960–2000.14 In this period both countries scored a 6% unemployment rate and the inflation rate amounted to 4% in the United States and to 5% in Europe. We proceed in two steps (see the ‘Appendix’ for details of calibrations). First we set the almost identical markups and the money scale parameter, c, necessary to meet the observed long run values of inflation and unemployment in the two economies.15 Then we identify the different combinations in the degree of wage centralization and in the labor elasticity of substitution, parameters n and r respectively, consistent with the markups and with the assumed differences in the two regional labor markets. In our exercise ‘‘Europe’’ should identify the ‘‘average’’ European country (‘‘EU’’ henceforth) characterized by sovereign monetary policy and country-specific labor market institutions.16 In Table 1 we present the employment losses (EL)17 and inflation rates (INF) under flexible wages and pre-determined wages that would obtain under the markup rule (21). In Europe predetermined wages imply that inflation is cut by more than one half and employment losses by more than one third with respect to the case of flexible wages. It is striking that substantial gains accrue from discretion even in the case of the United States. We test the robustness of the result by assuming alternative labor market calibrations. Gains from discretion fall as n rises, but become negligible only for n [ 200 (see Table 2). 5.3 The effects of distorted central bank preferences We now consider the case of distorted central bank’s preferences. Straightforward manipulations show that equilibrium employment amounts to 14 Note that our simulations are intended as a numerical exercise to illustrate our results. As such, they can only give a hint about a formal quantitative evaluation, which instead requires a more complex large scale model. 15 Admittedly, this model shares the widespread shortcoming that employment losses are defined as a gap in hours per worker. Strictly speaking there is no unemployment, per se. See Galı` and Gertler (2007) for a discussion. 16 We are not claiming here that the values of n are the ‘‘true’’ figures for the US and EU labor markets. We are instead showing that for our model to match the average inflation rates observed in the two areas, conditional to the rest of our calibration exercise, we must impose certain numerical values for n. 17

The employment loss is defined as the deviation from the Pareto optimal equilibrium.

123

226

Empirica (2013) 40:215–235

Table 1 Employment losses and inflation rates (% values)

US

Table 2 Outcomes under alternative (labor market) calibrations for the US

‘‘EU’’

INF

EL

INF

EL

Flexible wages

4.9

6.5

14.2

9.8

Pre-determined wages

4.0

6.0

5.0

6.0

Size of the representative union

Flexible wages

Gains from discretion

INF

EL

INF

EL

0.6% (n = 150)

4.6

6.3

0.6

0.3

0.5% (n = 200)

4.4

6.2

0.4

0.2

0.25% (n = 400)

4.2

6.1

0.2

0.1

0.16% (n = 600)

4.1

6.0

0.1

0.0

lc ¼

aq glec

1 !/þ1

ð36Þ

where lec ¼ l 

dc=cB a ðr  1Þðn  1Þ þ 1a

ð37Þ

Thus by setting cB ¼ cB ¼

h

cd

i n þ rðn  1Þ þ ð1  aÞ1  n ð1  qÞ

ð38Þ

distortions would be eliminated, and the inflation bias would correspondingly disappear. Choosing c*B \ c reinforces the disciplining effects of discretion, because the central bank inflates more in response to a wage increase when cB is low. Our simulations, however, sound a note of caution. In Fig. 2 we describe the effects of central bank’s conservatism (defined as cB - c) on inflation and employment loss. Labor market distortions and the inflation bias are eliminated for cB = c*B. Thus the Pareto optimum is restored. However, small deviations from this equilibrium18 may lead to catastrophic losses because of the non linearity of inflation as shown in the Fig. 2.19

18 These could occur because of shocks or imperfect information about the model parameters. Both features can be easily included in our framework. 19 Consider that, as said, welfare analysis is problematic in this context because of the infinite demand of money associated with the Friedman rule implementation.

123

Empirica (2013) 40:215–235

227

Fig. 2 Distorted preference (n = 50)

6 Commitment to a positive inflation rate The timing of the game is as follows. (1)

The central bank announces the growth rate of the money supply: Mtþ1 ¼ Mt ð1 þ m Þ

ð39Þ

In our framework, this is equivalent to setting an inflation target. (2) Before the price level is known, trade unions must choose the nominal wage rate, based on the rational expectation that Pet = Pt-1(1 ? m*). (3) The central bank implements the policy rule (39) and full price flexibility ensures that markets clear. 6.1 Derivation of the wage markup The union now maximizes the expected value of (1) subject to the expected values of (27), (28) and (8). Imposing rational expectations (pe = m), the latter becomes20  1e e cbCt;i Mt;i ¼ ð40Þ Pet 1 þ m  b

20

Equation (40) has been obtained using the Euler equation (7) under the expectation that Ct = Ct?1.

123

228

Empirica (2013) 40:215–235

Unions anticipate that real money balances will fall due to the adverse effect of the wage choice on consumption. Formally, the union’s first order condition in the symmetric equilibrium is:     a 1 ð1 þ dm Þ let ðr  1Þðn  1Þ þ 1a ðlet Þ1þ/ rðn  1Þ þ 1a ¼g ð41Þ et w Cte where: "  #1e  1 1 þ m  b e1 e 1e c ðCt Þ dm ¼ e b which is increasing in m*.21 Straightforward manipulations show that et ¼ glem ðlet Þ/ Cte w

ð42Þ

where: lem ¼

l 1 þ dm

ð43Þ

Pre-commitment to a positive inflation rate has unambiguous mark-up reducing effects. The size of moderation clearly depends on dm. A striking result is that precommitment has a disciplining role even in the limiting case of monopolistic competition, due to the anticipated impact of wage claims on money holdings (see (41)). In the following figure we describe the effects of changes in c and n on the employment loss associated to a 2% inflation target. Unlike the case of discretion, now the employment loss is highly sensitive to changes in c, whereas changes in the number of wage setters do not significantly affect the results. In Table 3 we show that the employment gain in setting a positive inflation target is sensitive to the value of the inverse money elasticity, e.22

6.2 Comparing the employment effects of commitment and discretion By definition the inflation rate obtaining under the discretionary equilibrium falls within the range of options available under commitment, but the relative employment performance of the two monetary regimes is conditional to the institutional features of the labor market. Under discretion, the wage markup is moderated by unions’ anticipation of the central bank’s reaction and thus is inversely related to the number of unions. Under commitment the disciplining effect of inflation obtains irrespective of the degree of labor market centralization.

21

Recall that e [ 1 for the marginal cost of inflation to be positive.

22

In our benchmark calibration we have assumed e ¼ 2:3.

123

Empirica (2013) 40:215–235

229

Table 3 Employment gains (%) with respect to zero targeting Inflation target (%)

Inverse money elasticity ðeÞ 1.6

1.8

2.0

2.2

2.4

2.6

2.8

3.0

3.2

2

0.87

0.82

0.76

0.70

0.64

0.59

0.55

0.51

0.47

4

1.53

1.45

1.36

1.26

1.16

1.08

1.01

0.94

0.88

6

2.06

1.99

1.87

1.75

1.63

1.52

1.42

1.33

1.25

Table 4 Differences in employment loss Inflation target (%)

Non-atomistic wage setters 20

25

50

75

100

200

300

0

-5.1

-1.9

0.8

1.2

1.4

1.7

1.9

2

-4.5

-1.3

1.4

1.9

2.1

2.4

2.5

4

-4.0

-0.8

1.9

2.4

2.6

2.8

2.9

6

-3.6

-0.4

2.3

2.8

3.0

3.3

3.4

Table 4 reports calibrations of the employment loss differentials associated to inflation targeting, relative to discretion, that arise as a consequence of the target, starting from the standard zero-inflation target, typically adopted in the literature.23 For a small number of wage setters, inflation targeting implies a worse performance than discretion, and vice versa. An increase in the number of wage setters has a very small effect on the employment loss of the targeting regime, but it strongly reduces the moderation effect under discretion.

7 Post-1980 disinflation and the labor market wedge. Can the model explain European unemployment? In this section we show that our emphasis on the role of ‘‘large’’ wage setters may offer a re-interpretation of the post 1980 different unemployment performance between Europe and the United States (Fig. 4). To explain these facts, Blanchard and Wolfers (2000) argued that European institutions performed relatively well in the 60s, when unemployment was in fact lower than in the United States, but proved unsuitable for the new, more turbulent macroeconomic environment following the oil shocks. This view was challenged in Nickell et al. (2005), who identify a specific role of changing institutions such as employment protection, unemployment benefits, variation in union density changes. According to their estimates, the adverse changes in labor market institutions explain around 55% of the rise in European unemployment from the 1960s to the first half of the 1990s. 23

In order to isolate the effects of the unionization from those arising from the inflation targeting, the table is built by calibrating the model to obtain in the discretionary equilibrium an unemployment rate equal to 6% and an inflation rate equal to 4% independent of the number of unions. See the ‘Appendix’ for details.

123

230

Empirica (2013) 40:215–235

Fig. 3 Inflation targeting and parameters

We offer a complementary interpretation based on the interaction between different labor market institutions and monetary policy regimes. Both in the United States and in Europe, the stagflationary shocks of the 70s caused an adverse shift in long-term inflation expectations. As documented in Clarida et al. (1999) the early 80s marked a watershed in monetary policy, as central banks in OECD countries committed to a low inflation regime. Our approach suggests that this induced an adverse effect on the labor market wedge in Europe, due to the particular importance of large wage setters. Our view is thus in line with the Nickell et al. (2005) results. In fact, our model indirectly suggests that in a disinflation period large wage setters should become more ‘‘militant,’’ i.e. union activism and wage claims should increase.24 Furthermore, the adverse changes in employment protection and unemployment benefits that contributed to raise unemployment could also be seen as the consequence of trade unions pressure. Between 1982 and 2004 Europe and the United States were characterized by almost identical average inflation rates, 2.1 and 1.9% respectively. We thus replicate our calibration experiment to obtain in both countries an inflation rate 2% by assuming that central banks turned more conservative, that is, we set cB at 0.7 in the United States and 0.76 in ‘‘EU’’ (case 1). We also consider the alternative where it is assumed that in both regions monetary policies endorsed a 2% inflation target. In Table 5 we document how the employment losses change relative to the benchmark case presented in row 2 of Table 1. Under both monetary regimes European disinflation entails a larger employment loss. The predictions of our model under a conservative central bank regime are consistent with the findings in Debelle and Fischer (1994), who show that the sacrifice ratio during the post oil shock disinflation was larger in Germany than in the US. We also find that an inflation 24 An emblematic case of unions’ activism in the 80s is offered by the Netherlands and Ireland (see Ebbinghaus and Visser 1997; Freeman 2007).

123

Empirica (2013) 40:215–235

231

Fig. 4 Unemployment rates in the United States and Europe

Table 5 Employment loss in a low inflation regime

US Conservative central bank Inflation targeting

EU

0.2

1.5

-2.1

1.2

targeting regime generates an employment gain in the US, were wage setters are relatively small. In this regard, from Fig. 4 it is interesting to note that, after an initial increase, unemployment actually falls in the US, whereas it remains high in Europe. Our result could be reconciled with US evidence if one accounted for the initially imperfect credibility of the regime shift. It should be emphasized, however, that these are suggestive interpretations, as the empirical relevance of our results cannot be taken for granted. Their assessment would require that we estimated a fully-fledged dynamic model. This is beyond the scope of the present work.

8 Concluding remarks Standard Barro and Gordon models assumed neutrality of the monetary policy regime and emphasized the importance of credibility for achieving inflation control. Our results show that the monetary regime choice may have real effects when the labor market is imperfectly competitive: monetary policies may take advantage of predetermined nominal wages to discipline monopolistic wage setters. This, in turn, requires a positive inflation rate. The real effects of monetary discretion are relatively strong when the labor market is characterized by relatively large wage setters. By contrast, the beneficial effects of precommitment to a positive inflation rate hold irrespective of the degree of labor market centralization. Further research should nest our wage-disciplining mechanism into a dynamic general equilibrium model where price rigidities and staggered nominal wage

123

232

Empirica (2013) 40:215–235

contracts allow to characterize inertia in price and wage inflation, investigating the response of wage markups over the business cycle in response to different shocks. This would allow to measure the empirical relevance of the theoretical mechanism discussed here. Finally, we call for a re-assessment of the output costs of disinflation (Ball 1994; 1997). In fact, both early cross sectional evidence suggesting that central bank independence is positively related to sacrifice ratios (Fischer 1996; Ga¨rtner 1997; Jordan 1997; Posen 1998) and more recent contributions showing that inflation targeters enjoyed more favorable sacrifice ratios should be reconsidered controlling for the role played by ‘‘large’’ wage setters. This also is left for future research. Acknowledgments The authors are grateful to G. Ascari, P. Benigno, H. Dixon, A. Cukierman, A. Dalmazzo, F. Giuli, S. Gnocchi, A. Hughes Hallett, L. Lambertini and D. Soskice for useful comments and discussions on previous drafts. We acknowledge financial support by MIUR (PRIN).

Appendix In our quantitative assessments, we calibrate the model and investigate the quantitative relevance of our theoretical results. We begin by modeling two hypothetical economies characterized by a similar macroeconomic performance but substantially different with regard to wage-setting behavior. We set baseline parameters consistent with the long run macroeconomic performance of the United States and Europe, in terms of inflation and unemployment averages over the period 1960–2000. Considering the former as a case of a country with a low union density and the latter as a case of a more unionized area.25 In our exercise ‘‘Europe’’ should then be identified as an ‘‘average’’ European country (‘‘EU’’ henceforth). Both regions scored a 6% unemployment rate; the inflation rate amounted to 5% in the United States and to 4% in Europe. In calibrating the model we follow a three-step procedure. We first set some common parameters in line with those used in the literature; then we set the almost identical markups and the money scale parameter, c, necessary to meet the observed long run values of inflation and unemployment in the two economies; finally, we identify the different combinations in the degree of wage centralization and in the labor elasticity of substitution, parameters n and r respectively, consistent with the markups and with the assumed differences in the two regional labor markets.26 We set the labor coefficient a at 0.6, the discount rate (b) at 0.97, corresponding to a yearly long-term real interest rate of 3% , the labor supply elasticity (1//) at 0.47;27 and determine the scale parameter of labor disutility (g) to obtain a Pareto 25 In the United States the number of unions affiliated to the AFL-CIO in the United States is about 50– 60. In major countries of continental Europe the number of industry unions ranges from about 15 in Germany to about 40 in Italy. In Europe, however, industry unions are heterogeneously affiliated to different confederations and thus their action is partially coordinated. See Rhodes (2001), Visser (2002, 2007). 26

As said in the main text, in this model employment losses are defined as a gap in hours per worker.

27

Our results are robust to different reasonable specifications of labor supply elasticity. Evidence from microdata suggests a labor supply elasticity is mostly concentrated in the range of 0.05–0.6. See Card (1994) for a survey, Mulligan (1999, 2002) for a discussion.

123

Empirica (2013) 40:215–235

233

Table 6 Parameters of our benchmark scenario Common parameters Labor coefficient

0.6

Discount rate

0.97

Labor supply elasticity

0.47

Money demand elasticity

0.43

Non distorted employment

1/3

Price markup

1.10

Specific country parameters

US

EU

Money scale parameter

0.56

0.47

Strategic wage setters

US

EU

100

25

optimal level of employment equal to 1/3. We assume the money demand elasticity ð1=eÞ to be 0.43.28 Given these assumptions, the total markup (ld/q) necessary to obtain the 6% unemployment rate in the two countries amounts to 1.21. Finally, assuming discretionary monetary policy, we set the money parameters consistent with the average inflation rates observed in Europe (c = 0.47) and in the United States (c = 0.56).29 Turning to our calibration of the two regional labor markets, we set n at 25 for the ‘‘EU’’ and 100 for the United States. Correspondingly, the values for r are 5 and 9.6 respectively. The common and country-specific parameters of our benchmark are summarized in Table 6. In our baseline calibration the wage markup is equal to 1.10.30 In Fig. 2, we have also considered the intermediate case of n = 50 (with r equal to 8). In Table 4 we have isolated the effects of the unionization from those arising from the inflation targeting; given the degree of unionization (n), r and c are thus chosen to obtain 4% inflation and 6% unemployment; then in each column the effect of the targeting is compared. The table is calibrated for the case of n = 100, i.e. the ‘‘US’’. We have also checked the robustness of our results with respect to other standard functional forms for the agents’ preferences. Results are available upon request.

28

See e.g. Choi and Oh (2003), Dib (2004), Knell and Stix (2005) and references therein.

29

Note that the money scale parameters, which are endogenously determined, are close to those used by Christiano et al. (2005). 30 We also test the robustness of our results by considering two alternative scenarios where the parameters are the same as those reported in Table 5, but the labor market elasticity of substitution (r) is chosen to obtain different wage markups: 1.05 and 1.15. The former is closer to the calibration for the United States of Christiano et al. (2005); the latter to that of Gali et al. (2007). See also Altig et al. (2011).

123

234

Empirica (2013) 40:215–235

References Acocella N, Di Bartolomeo G, Hibbs DA (2008) Labor market regimes and monetary policy. J Macroecon 30:134–156 Altig DE, Christiano L, Eichenbaum M, Linde J (2011) Firm-specific capital, nominal rigidities, and the business cycle. Rev Econ Dyn 14:225–247 Ball LN (1994) What determines the sacrifice ratio?. In: Mankiw GN (eds) Monetary policy. University of Chicago Press, Chicago Ball LN (1997) Disinflation and the NAIRU. In: Romer CD, Romer DH (eds) Reducing inflation: motivation and strategy. University of Chicago Press, Chicago Benigno P, Ricci LA (2010) The inflation-output trade-off with downward wage rigidities. Am Econ Rev (forthcoming) Blanchard O, Wolfers J (2000) The role of shocks and institutions in the rise of European unemployment: the aggregate evidence. Econ J 110:1–33 Bratsiotis G, Martin C (1999) Stabilisation, policy targets and unemployment in imperfectly competitive economies. Scand J Econ 101:241–256 Canova M, Menz T (2011) Does money matter in shaping domestic business cycles? An international investigation. J Money Credit Bank (forthcoming) Card D (1994) Intertemporal labor supply: an assessment. In: Sims C (eds) Advances in econometrics, vol. II. Cambridge University Press, Cambridge, pp 40–78 Choi WG, Oh S (2003) A money demand function with output uncertainty, monetary uncertainty, and financial innovations. J Money Credit Bank 35:685–709 Christiano LJ, Eichenbaum M, Evans C (2005) Nominal rigidities and the dynamic effects of a shock to monetary policy. J Polit Econ 113:1–45 Clarida R, Galı` J, Gertler M (1999) The science of monetary policy. J Econ Lit 37:1661–1707 Coricelli F, Cukierman A, Dalmazzo A (2006) Monetary institutions, monopolistic competition, unionized labor markets and economic performance. Scand J Econ 108:39–63 Corsetti G, Pesenti P (2001) Welfare and macroeconomic interdependence. Q J Econ 116:421–446 Cukierman A (2004) Monetary institutions, monetary union and unionized labor markets—some recent developments. In: Beetsma R, Favero C, Missale A, Muscatelli VA, Natale P, Tirelli P (eds) Monetary policy, fiscal policies and labour markets: key aspects of macroeconomic policymaking in EMU. Cambridge University Press, Cambridge Cukierman A, Lippi F (1999) Central bank interdependence, centralization of wage bargaining, inflation and unemployment—theory and evidence. Eur Econ Rev 43:1395–1434 Debelle G, Fischer S (1994) How independent should a central bank be?. In: Fuhrer JC (eds) Goals, guidelines, and constraints facing monetary policymakers. Federal Reserve Bank of Boston, Boston Dib A (2004) Nominal rigidities and monetary policy in Canada. J Macroecon 28:303–325 Du Caju P, Gautier E, Momferatou D, Ward-Warmedinger M (2008) Institutional features of wage bargaining in 22 EU countries, the US and Japan. ECB Working Paper No 974 Ebbinghaus B, Visser J (1997) A Dutch miracle. Amsterdam University Press, Amsterdam Erceg C, Henderson D, Levin AT (2000) Optimal monetary policy with staggered wage and price contracts. J Monet Econ 46(2):281–313 Fischer AB (1996) Central bank independence and sacrifice ratios. Open Econ Rev 7:5–18 Freeman RB (2007) Searching for the EU social dialogue model. In: Acocella N, Leoni R (eds) Social pacts, employment and growth: essays in honor of Ezio Tarantelli. Physica-Verlag, Berlin Galı` J, Gertler M (2007) Macroeconomic modeling for monetary policy evaluation. J Econ Perspect 21:25–45 Galı` J, Gertler M, Lo`pez-Salido JD (2007) Markups, gaps, and the welfare costs of business fluctuations. Rev Econ Stat 89:44–59 Gnocchi S (2009) Non-atomistic wage setters and monetary policy in a New-Keynesian framework. J Money Credit Bank 41:1613–1630 Ga¨rtner MB (1997) Central bank independence and the sacrifice ratio: the dark side of the force. Swiss J Econ Stat 133:513–538 Goodfriend M, King R (1997) The new neoclassical synthesis and the role of monetary policy. NBER Macroeconomics Annual 1997, pp 231–296 Graham L, Snower DJ (2008) Hyperbolic discounting and the Phillips Curve. J Money Credit Bank 40:427–448

123

Empirica (2013) 40:215–235

235

Guzzo V, Velasco A (1999) The case for a populist central banker. Eur Econ Rev 43:1317–1344 Holden S (2005) Monetary regimes and the coordination of wage setting. Eur Econ Rev 49:833–843 Ireland PN (1999) Does the time-consistency problem explain the behavior of inflation in the United States? J Monet Econ 44:279–292 Knell M, Stix H (2005) The income elasticity of money demand: a meta-analysis of empirical results. J Econ Surv 19:513–533 Jordan TB (1997) Disinflation costs, accelerating inflation gains, and central bank independence. Weltwirtschaftliches Archiv 1:1–21 Lippi F (2003) Strategic monetary policy with non-atomistic wage setters. Rev Econ Stud 70:909–919 Mishkin F, Posen AS (1997) Inflation targeting: Lessons from four countries. Econ Policy Rev. Federal Reserve Bank of New York, issue Aug: 9-110 Mulligan CB (1999) Substitution over time: another look at life-cycle labor supply. In: Bernanke B, Rotemberg J (eds) NBER macroeconomic annual 1998. The MIT Press, Cambridge, pp 75–134 Mulligan CB (2002) A century of labor-leisure distortions. NBER Working Paper No. 8774 Neiss KS (1999) Discretionary inflation in a general equilibrium model. J Money Credit Bank 31:357–374 Nickell S, Nunziata L, Ochel W (2005) Unemployment in the OECD since the 1960s. What do we know? Econ J 115:1–27 Posen A (1998) Central bank independence and disinflationary credibility: a missing link?. Oxford Econ Papers 50:335–359 Rhodes M (2001) The political economy of social pacts: ‘competitive corporatism’ and European welfare reform. In: Pierson P (eds) The new politics of the welfare state. Oxford University Press, Oxford, pp 165–194 Rogoff K (1985) The optimal degree of commitment to an intermediate monetary target. Q J Econ 100:1169–1190 Schmitt-Grohe´ S, Uribe M (2004) Optimal fiscal and monetary policy under sticky prices. J Econ Theory 114:198–230 Schmitt-Grohe´ S, Uribe M (2007) Optimal inflation stabilization in a medium-scale macroeconomic model. In: Schmidt-Hebbel K, Mishkin R (eds) Monetary policy under inflation targeting. Central Bank of Chile, Santiago, pp 125–186 Soskice D, Iversen T (1998) Multiple wage-bargaining systems in a single European currency area. Oxford Rev Econ Policy 14:110–124 Soskice D, Iversen T (2000) The nonneutrality of monetary policy with large price or wage setters. Q J Econ 115:265–284 Svensson LEO (1997) Optimal inflation targets, ‘conservative’ central banks, and linear inflation contracts. Am Econ Rev 87:98–114 Visser J (2002) Unions, wage bargaining and co-ordination in European labour markets. In: Pochet Ph (eds) Wage and policy in the Eurozone. PIE Peter Lang, Bruxelles Visser J (2007) Wage bargaining institutions in Europe. A happy marriage or preparing for divorce?. In: Acocella N, Leoni R (eds) Social pacts, employment and growth: essays in honor of Ezio Tarantelli, Physica-Verlag, Berlin Woodford M (2003) Interest rate and prices. Princeton University Press, Princeton

123