Optimal monetary policy under
labor market frictions: the role of
wage rigidity and markup shocks
shocks.2
In this chapter, I take up the recent criticism and suggestions by Haefke, Sonntag, and van Rens (2008) and Pissarides (2009) with respect to such an approach. They argue that using a uniformly rigid real wage is not consistent with empirical evidence.
As an alternative mechanism to address the unemployment volatility puzzle, the lat-ter author suggests extending the models to include additional driving forces. Ac-cordingly, I investigate optimal monetary policy in an environment with labor market frictions, heterogeneous wage setting, and markup shocks. My contribution is twofold.
First, I investigate the implications of introducing heterogeneous wage setting which is consistent with the aforementioned authors’ empirical findings for equilibrium alloca-tions, and specifically, labor market dynamics and optimal monetary policy. Second, I examine the consequences of introducing additional driving forces in the form of markup shocks for the dynamic responses of inflation and unemployment to those shocks under different monetary policy regimes.
The two independent studies by Haefke, Sonntag, and van Rens (2008) and Pis-sarides (2009) challenge the empirical relevance of a uniformly rigid real wage, for example, in the spirit of Hall’s (2005) “wage-norm” idea. They show by either per-forming their own empirical investigation or surveying empirical evidence on wage rigidity, that the wages which are rigid, are those of workers in ongoing job relation-ships, whereas wages for new hires are highly cyclical. Moreover, as these authors argue, the relevant wage series for search and matching models is wages for new hires.
Consequently, since empirically the latter move one-for-one with labor productivity and Nash bargaining implies wages which are highly responsive to changes in produc-tivity, it is consistent with the data to employ this standard mechanism to determine wages. Thus, the authors conclude that wage rigidity cannot be the answer to the unemployment volatility puzzle.
Accordingly, in the first part of this chapter, I introduce heterogeneous wage set-ting into a New-Keynesian dynamic stochastic general equilibrium (DSGE) model featuring labor market frictions in terms of hiring costs, following Blanchard and Gal´ı (2010). Their model constitutes a particularly convenient benchmark and starting
2See, for instance, Shimer (2005).
point due to its transparency as well as sharp results concerning the efficient alloca-tion. The latter makes it very easy to trace the effects of introducing features like heterogeneous wage setting and additional driving forces. At the same time, it gives an analytical relation between the dynamics of the economy and the underlying charac-teristics of the labor market. Blanchard and Gal´ı (2010) also take the standard route of the literature of introducing an overall rigid wage, which constitutes the starting point of my investigation. In order to introduce heterogeneous wage setting into their setup, I distinguish between two kinds of workers: those in ongoing job relationships and newly hired workers. Opposed to Blanchard and Gal´ı (2010), who introduce a rigid real wage for every worker, and consistent with the empirical studies mentioned above, I assume that only ongoing workers earn a rigid real wage in the spirit of Hall (2005). New hires, on the other hand, bargain over the wage for the current period, modeled by employing the generalized Nash solution. The main finding of this section is that with only these minor changes to the Blanchard and Gal´ı (2010) setup, and despite an economy-wide average sticky wage, the inflation unemployment trade-off which they obtain in their model with an overall sticky wage disappears. This is because the expected wage sum and thus the expected labor costs for an individual worker over the course of her tenure at an individual firm moves one for one with labor productivity. This, in turn, eliminates potential hiring incentives, leading to unchanged employment and unemployment levels in response to technology shocks, which corresponds to the constrained efficient allocation. Consequently, introducing a form of wage rigidity which is consistent with empirical evidence leaves the monetary authority with a single target. It can solely focus on inflation with no concern for employment stabilization.
However, this still leaves open the question of what other mechanisms can ac-count for the observed fluctuations in unemployment and what are the implications for monetary policy. In the second part of this chapter, I therefore examine the conse-quences of introducing an alternative approach to address the unemployment volatility puzzle. In particular, following the suggestion of Pissarides (2007),3 I incorporate ad-ditional driving forces in the form of markup shocks into the New-Keynesian DSGE
3This is the more extensive working paper version of Pissarides (2009).
model with heterogeneous wage setting described above.4 Following Steinsson (2003) and Rotemberg (2008), the elasticity of substitution in the Dixit-Stiglitz constant-elasticity-of-substitution (CES) consumption aggregator is assumed to be stochastic.
As a result, the elasticity of demand and thus the desired markup are also stochas-tic. This can be interpreted as a constantly changing market power of firms due to changes in substitutability of the different varieties of goods. The consistency of markup fluctuations with empirical evidence can be seen from, for example, Rotem-berg and Woodford (1991, 1999) and, more recently, Gal´ı, Gertler, and L´opez-Salido (2007). In my setup, shocks to the market power of firms and consequently move-ments in the desired markup feed via markup pricing into price dynamics and via resulting shifts in the labor demand schedule into employment and unemployment dynamics. Furthermore, a short-run inflation unemployment trade-off emerges, which I study by calibrating the system and simulating the movements of the endogenous variables in response to shocks under different monetary policy regimes. In this re-gard, I consider three different policies: first, completely stabilizing unemployment, which brings about the allocation of the latter variable in the constrained efficient allocation. Second, I investigate a policy of perfect inflation stabilization. In stan-dard New-Keynesian models, which do not feature a trade-off, such a policy would be optimal. Optimality is used here in the sense of the utility-based approach to welfare analysis, as extensively described in, for example, Woodford (2003). Ultimately it means minimizing a loss function derived from the preferences of the private agents and the equilibrium conditions of the model. Finally, I consider optimal monetary policy in the preceding sense. The investigation is rounded off by deriving the effi-cient policy frontier, i.e., the plot of the standard deviations of unemployment and inflation under a policy of optimal commitment while varying the relative weight on
4Both Mortensen and Nagyp´al (2007) as well as Hall and Milgrom (2008) also point out by running simple regressions of labor market variables on productivity measures that one cannot expect productivity shocks to be the only source of fluctuations in unemployment, as implicitly assumed by Shimer (2005). Similarly, Balleer (2009) shows by employing a structural vector autoregression (SVAR) that the standard deviations of different labor market variables conditional on identified technology shocks are a lot smaller than the corresponding unconditional quantities. Consequently, all those authors emphasize the importance of alternative driving forces with respect to the labor market to match the observed (unconditional) moments.
unemployment stabilization in the monetary authority’s loss function from zero to one. The main finding of this exercise in a setup with labor market frictions, hetero-geneous wage setting, and markup shocks again supports the result of the literature concerning the importance of price stability.5 Moreover, using markup shocks within the framework employed in this chapter, it is difficult to generate a significant amount of volatility in unemployment.
Concerning the related literature, not much work has been done on optimal mon-etary policy in an environment exhibiting labor market frictions. The main contri-butions in this area are Arseneau and Chugh (2008), Thomas (2008), Faia (2008, 2009), and Blanchard and Gal´ı (2010). The two articles by Ester Faia study optimal monetary policy in an environment with monopolistic competition, price adjustment costs, and matching frictions in the labor market. Faia (2008), in addition, intro-duces wage rigidity in the spirit of Hall (2005). In her two articles, she considers optimal policy in the sense of both a globally optimal as well as constrained Ram-sey approach and in terms of simple interest rate reaction functions. However, she neither looks at heterogeneous wage setting nor at alternative approaches to address the unemployment volatility puzzle. Thomas (2008) incorporates matching frictions into a New-Keynesian model and studies the effects of staggered nominal wage bar-gaining `a la Gertler and Trigari (2009). The latter leads to a setup where inflation stabilization is not optimal. While he considers some type of wage heterogeneity, he does not distinguish between wages for ongoing workers and new hires, even though empirical evidence suggests the importance of such a differentiation.6 Furthermore, he only looks at productivity shocks. Arseneau and Chugh (2008) consider a DSGE model with search and matching frictions in the labor market and costs of adjusting nominal wages to study optimal monetary and fiscal policy via the Ramsey approach.
They do not focus, however, on tackling the unemployment volatility puzzle, and ab-stract from heterogeneous wage setting. Blanchard and Gal´ı (2010), finally, start out from a simple New-Keynesian model with labor market frictions, where they intro-duce an ad-hoc rigid real wage in the sense of Hall (2005). This leads to a sizable
5See, for example, Woodford (2003).
6In particular, he assumes “that workers hired in between contracting periods receive the same wage as continuing workers” (p. 943).
short-run inflation unemployment trade-off. They only consider a uniformly rigid real wage, however, and do not take into account other possible approaches to generate data-consistent fluctuations in labor market variables.
The remainder of Chapter 2 is organized as follows. Section 2.2 presents a sim-ple New-Keynesian model featuring labor market frictions following Blanchard and Gal´ı (2010). I incorporate heterogeneous wage setting into this framework and study the implications for the resulting equilibrium allocation. In Section 2.3, I introduce markup shocks into the New-Keynesian model with heterogeneous wage setting de-rived in the preceding section. Different monetary policy regimes in this environment are studied in Section 2.4. In particular, I calibrate the model and simulate the dynamic responses of the endogenous variables to shocks to the elasticity of substitu-tion under those monetary policy regimes and calculate the efficient policy frontier.
Finally, Section 2.5 concludes.