ECON 5110 Class Notes

Staggered Wages

1 Introduction

A popular method for generating persistence and wage/price stickiness in current macro models is through
staggered contracts. The earliest work in this area is credited to Stanley Fischer (1977) and John Taylor
(1979, 1980). I will focus on the Taylors (1979) AER article. Taylors model is important because it
presents a framework where aggregate demand disturbances can have real eects that are spread out over
long periods of time (i.e., display persistence) without sacrificing rational expectations. It also produces a
familiar Phillips curve tradeo.

2 Taylors (1979) Model

2.1 Staggered Wage Setting

Begin by assuming that firms and workers negotiate labor contracts that specify fixed nominal wages for
two periods (i.e., one year). Contracts are staggered. Half are set in January and half in July. The wage
setting equation is
xt = bxt1 + dxt+1 + (byt + dyt+1 ) + t (1)

where

xt is the log of the contract wage in period t;

b, d and are positive parameters with b + d = 1;

yt is log excess demand (i.e., log output gap);

a hat over a variable represents rational expectations based on time t 1 information.

Firms, unions and workers care about relative wages. Therefore, when setting wages in the beginning
of period t (which will be in eect through periods t and t + 1), agents care about wages set in period t 1
(known with certainty) and wages to be set in period t + 1 (unknown in period t). Agents also care about
labor-market conditions throughout periods t and t + 1, as measured by yt .

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2.2 Money Demand

Money demand is taken from the quantity equation

mt = yt + wt vt (2)

where

mt is the log of money demand;

wt is the log of the aggregate wage level;

vt is a velocity shock.

The aggregate wage level is assumed to follow

wt = 0.5(xt + xt1 ). (3)

2.3 Money Supply

Money supply is given by a simple policy rule. Assume that the monetary authorities set the money supply
according to
mt = gwt (4)

where g is indicates the degree of accommodation to changes in the aggregate wage level. If g = 0, then the
central bank does not accommodate wage changes. If g = 1, then they accommodate them one-for-one.

2.4 Aggregate Demand

By equating equations (2) and (4), we get the aggregate demand curve

yt + wt vt = gwt or

yt = wt + vt (5)

where = 1 g.

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2.5 Solving for the Reduced Form

The model currently has three equations in three endogenous variables (wt , xt and yt ). The system can be
collapsed down to a single linear expectational dierence equation by substituting equations (5) and (3) into
equation (1). This produces

xt = bxt1 + dxt+1 + (b((0.5(xt + xt1 )) + vt ) + d((0.5(xt+1 + xt )) + vt+1 )) + t

xt = bxt1 + dxt+1 0.5b xt 0.5b xt1 0.5d xt+1 0.5d xt

0 = [b 0.5b]xt1 + [0.5b 0.5d 1]xt + [d 0.5d]xt+1

0 = bxt1 cxt + dxt+1 (6)

where
1 + 0.5
c= .
1 0.5

Equation (6) is of the same form we have analyzed throughout the semester a linear dynamic rational
expectations dierence equation. We have solved this type of model using repeated substitutions and using
Farmers eigenvalue method. Another solution technique is that of undetermined coecients (see Romer
section 6.6 or Blanchard and Fischer appendix 5A). First, we guess the form of the solution (based on
experience) with coecients to be determined

xt = xt1 + t . (7)

Using equation (7) to form expectations xt and xt+1 , we equate coecients to find

c [c2 4d(1 d)]0.5

Using equations (7) and (3), we get the reduced form for aggregate wage dynamics

wt = wt1 + 0.5( t + t1 )
X
= 0.5 i ( ti + t1i )
i=0

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and the reduced form for output dynamics

yt = yt1 0.5( t + t1 ) + (vt vt1 )

2.6 Interpreting the Results

2.6.1 Phillips Curve Tradeo

Output and wage dynamics are governed by the parameter . Lower values of lead to less persistence
(i.e., higher stability) in aggregate wages. Note also that g and are positively related. Therefore, the
central bank can generate more stability in aggregate wages by making g small. However, this comes at
an expense. Lower values of g imply higher values of and thus a flatter aggregate demand curve. This
means that shocks to contract wages will lead to more output volatility. The tradeo exists in reverse if the
central bank is more accommodative (i.e., makes g large).
The Phillips curve tradeo can be summarized as follows:

Accommodative policy (g high, low) low variation in y and high variation in w;

Not accommodative policy (g low, high) high variation in y and low variation in w.

2.6.2 Degree of Forward-Looking Behavior

It is interesting to see how wage and output dynamics depend on the degree of forward-looking behavior.
As expected, wage persistence (as measured by ) is decreasing in d. This makes intuitive sense. Consider
the limiting case of d = 1, where agents only look forward to next periods wage. In this case, = 0 and a
shock to the contract wage only lasts as long as the contract period. On the other hand, when d = 0 and
agents only look backwards, is very nearly one and wages are very persistent. In sum,

Only forward-looking behavior (b = 0, d = 1, = 0) low persistence in w and y;

Only backward-looking behavior (b = 1, d = 0, ' 1) high persistence in w and y.

2.6.3 Hump-Shaped Impulse Response Functions

A well-known feature of U.S. output is that it displays a hump-shaped impulse response that peaks somewhere
in the neighborhood of four quarters. For example, if we let b = d = 0.5, = 0.2, g = 0.5 and vt = 0 for all

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t, we get the following equation for output dynamics

yt = 0.635yt1 0.25( t + t1 ),

which is an ARMA(1,1) process. Assuming y0 = 0 = 0, 1 = 1 and t = 0 for all t > 1, we get the
following sequence for output:
period (j) yj

0 0
1 0.25
2 0.41
3 0.26
4 0.17

Therefore, a one-time shock to the contract wage produces a hump-shaped response for output that peaks
at four quarters (i.e., one year) after the shock.

3 Menu Costs

Student presentation.