Nominal-wage contracts and real activity: evidence from the German economy.

• Author: Mohammadi, Hassan

1. Introduction

   The research on microfoundations of the Phillips Curve over the last two decades has produced two alternative new-classical explanations of the short-run output-inflation trade-off: the nominal-wage contracting variety explanation of Fischer [4] and Gray [7], and the equilibrium explanation of Lucas [11].(1) Both explanations are similar in their prediction that real activity responds to aggregate demand disturbances through price surprises that they generate. They are very different, however, in mechanisms that generate such response.

   The contracting theory emphasizes the existence of long-term contractual arrangements that, in their simplest form, fix wage schedules in nominal terms for a predetermined period (the life of the contract) and leave the level of employment at the discretion of the firm. In this framework, a positive aggregate demand shock that occurs after the contract negotiation date will cause an increase in the general price level, a decrease in the real wage, and an increase in employment and output.

   By contrast, the equilibrium theory makes imperfect information central to the non-neutrality of nominal disturbances. According to this theory, agents lack full current information about aggregate variables and thus cannot dichotomize unanticipated price movements into their relative and absolute components. In this framework, unanticipated changes in aggregate demand lead to positive movements in output and employment because their price level effects are confused with relative price movements.(2) Differences between the contracting and equilibrium explanations of the response of real activity to aggregate demand shocks provide empirically testable hypotheses. Gray, Kandil, and Spencer [8] test for the proposition that, while both theories predict a positive output response to aggregate demand shocks, the size of the response is larger in the contracting model than in the equilibrium alternative. Their results, based on U.S. industry data, overwhelmingly support this prediction.(3) David Card [1I investigates the response of employment to real wage changes induced by aggregate price surprises. His results, using data on individual contracts in the unionized sector of Canadian manufacturing, support the prediction of the simple contracting model: employment responds negatively to real wage changes induced by aggregate price surprises.

   This paper provides additional support for the role of nonminal-wage contracts by investigating another distinctive prediction of this theory. This prediction is in regard to the effect of multi-step-ahead aggregate demand shocks on aggregate real activity. More specifically, if contracts are multi-period and synchronized, the cyclical pattern of real activity in the contracting model will depend on multi-step-ahead aggregate demand disturbances. By contrast, the equilibrium model acknowledges a role for only one-step-ahead disturbances.

   Overlapping contracts, a major characteristic of contracts in the U.S. labor market, tend to disguise the distinctive time series behavior of aggregate real activity implied by the simplest synchronized contracting model. Adjustment costs further reduce the feasibility of distinguishing empirically between the two models by driving the cyclical as well as the secular components of real activity away from the predictions of the simplest synchronized contracting model.

   This study minimizes the difficulties posed by overlapping contracts by employing data on aggregate real activity pertaining to an economy in which contracts are essentially synchronized. Evidence suggests that the German economy meets this requirement. Most annual wage contracts in this economy are negotiated at the end of the first quarter and the beginning of the second quarter of each year and cover the subsequent four quarters.(4) Thus the validity of the contracting model can be tested by investigating the effect of two-to-four step ahead aggregate demand disturbances on aggregate real activity.

   The empirical results suggest that multi-step-ahead aggregate demand disturbances had positive and statistically significant effects on three measures of real activity in the West German economy - real GNP, industrial production, and industrial employment - over the 1965.I-86.IV sample period.(5) Thus, nominal-wage contracts might play an important role in determining aggregate real activity. The remainder of the paper is organized as foflows: section II highlights the theoretical implications of the contracting and equilibrium models and formulates their distinguishing implications, section...