Ebook Discretion versus commitment with large wage setters
For long it has been acknowledged that under standard assumptions monetary policy can only have short term real effects but no lasting or structural consequences. However Soskice and Iversen (2000) (here after SI) have shown that this result is no longer valid when there are large price or wage setters.
Monetary policy has structural consequences because it can reduce the price or wage markups of these large agents. When agents have a large or macroeconomic size, they are able to anticipate the macroeconomic consequences of their decisions on variables such as the price index and the (real) aggregate demand. Now if the central bank sets its money supply (which in a way or another affects aggregate demand) on the ground of the prices or wages set by the large agents, the relation between these prices or wages and aggregate demand is modified. It implies that the monetary policy affects equilibrium prices or wages. It just requires that large agents anticipate correctly the relation between their price or wage and the money supply.
All things considered, this result is not just a vagary. In Europe, wage setting is often highly centralized, labor unions have a large macroeconomic size and are well organized. This does not constitute a novelty: stratetic interactions between a central bank and large labor unions is at the root of an important economic literature, that can be traced back to e.g. Aukrust (1977). Important comprehension gains could follow from the integration of the SIes mechanism into the analysis of the European monetary policy.
As such, this mechanism suffers from one shortcoming: it rests on rule and commitment (instead of inflation surprise and discretion). That constitutes an important limitation to SIes result as the central bank generally lacks a commitment device. For the sake of realism, and to get integrated in the core of the monetary policy literature, the real effectiveness of monetary policy still needs to be proven under discretion and compared with the commitment case.
Recently Coricelli, Cukierman and Dalmazzo (2005) have shown that the SIes mechanism is also at work with a discretionary monetary policy. The present paper comes back on this rather unnoticed result. As under commitment, the central bank follows a monetary regularity that links the money supply to (observed) prices or wages. Rational large agents can anticipate this regularity and adjust their optimal behavior accordingly. I extend Coricelli et al. (2005) by comparing economic outcomes with and without commitment. The difference comes not only from inflation but also from the real variables such as employment and welfare.
For the sake of simplicity, the only source of competitive distortion locates on the labor market. I use a simple model with sound micro foundations where two sectorial monopolistic labor unions set nominal wages non cooperatively before the central bank decides of its money supply. The sectorial goods markets are competitive. On each sectorial market, a representative firm takes the sectorial wage as given. A more general formulation where several sectorial labour unions bargain wages with associations of employers would not affect the results provided that all sectorial bargainings occur simultaneously and independantly1. But the possible gain in realism would entail a rise in complexity that could somewhat blur the picture.
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