New-Keynesian (NK) models have been extensively used in recent years to analyze the impact of monetary policy on business cycle fluctuations and to provide guidelines in the design of optimal monetary policy rules.
NK literature commonly disregards potential strategic interaction between policy makers and large wage setters. Yet, collective wage bargaining is a distinctive feature of labor markets in most of OECD countries. In addition, countries differ in terms of centralization of the wage bargaining process, ranging from completely decentralized, such as the US and the UK, to highly centralized, such as Norway. In centralized countries, negotiations are delegated to few large unions, whose decisions affect the aggregate level of wages, which is turn one of the main forces driving the real cost of labor and, as consequence, inflation. In such an environment, strategic interaction is an issue: a rise in the bargained wage calls for policy action on the part of the central bank, as long as the objective of price stability is at risk.
The topic has recently attracted the interest of a part of the literature. Bratsiotis and Martin (1999), Iversen and Soskice (2000) and Lippi (2002, 2003) among others show that, in the presence of a unionized labor force, the systematic behavior of the central bank has an impact on labor supply decisions and, as a consequence, on the long-run equilibrium level of employment and production. Existing contributions have not yet exploited the tools developed by the NK research program.
This paper bridges the gap between these two strands of the literature and integrates the NK model with the monetary policy rule non-neutrality arising in the presence of non-atomistic wage setters. I contribute to the NK literature by adding some new insight. I show that the benefits associated to inflation stabilization increase in the centralization of the wage bargaining process. It follows that the monetary policy trade-off traditionally considered in the literature may be altered in favor of more conservative policies, depending on the wage setting institutions.
This is because strategic interaction creates an additional transmission channel of monetary policy acting through labor supply rather than aggregate demand, which is allowing the central bank to increase steady state employment by being tougher in stabilizing inflation. Moreover, the strength of the channel increases in wage setting centralization. The classical neutrality result is not challenged: a temporary shock to the policy instrument dies off in the long-run. A change in the policy rule, however, has a permanent real effect. These results are in line with the findings by Bratsiotis and Martin (1999) and Iversen and Soskice (2000).
In this setting, price stability is consistent with the elimination of any deviation of real economic activity from Pareto efficiency and it is, as a consequence, the optimal policy. The outcome distinguishes the model outlined here from the standard NK, where without the proper fiscal policy, zero inflation under full commitment, though optimal, can be reached only at the cost of a suboptimal production level. The introduction of other distortions, such as wage stickiness, would introduce a tension between inflation and output gap stabilization and would then undermine the policy implication. Still, the main message would survive: concentrated labor markets provide an additional reason to stabilize inflation fluctuations other than the usual concerns about relative price dispersion. The result does not imply per se any long-run trade-off between inflation and employment: the efficient level of employment is implemented through inflation stabilization around the target, without necessarily requiring average positive inflation.
The assumption that wage setters have positive mass buys all the results. The aggregate wage feeds into inflation through firm’s price setting. Large workers realize that they can affect the aggregate wage. Hence, they anticipate that aggressive wage policies create inflation leading to labor demand reductions through restrictive monetary policy. The labor demand reduction is harsher, the tougher is monetary policy in pursuing the objective of price stability. It follows that labor demand elasticity increases in the degree of inflation stabilization. Through this channel, the central bank can restrain wages so as to increase via labor demand the steady state level of employment.
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