Macroeconomics
Lecture 10
The sticky wage model.
Outline
• The assumptions of the sticky wage
model
• Deriving the AS curve
• Lecture note 2 (available on my webpage)
Misperception and rational
expectations
Under RE workers do not make systematical
expectation errors but still they DO make mistakes!
Misperceptions related to imperfect information and
confusion about random shocks.
Keynesian and New Keynesian
theories of the cycle
Inflexible wages and prices prevent
the economy from adjusting immediately
to shocks
• Sticky price model (menu costs)
• Sticky wage model (wage contracts)
• Nominal rigidities = low responsiveness of W (or P) to changes in AD
• Real rigidities = low responsiveness of W/P to changes in AD
Main assumptions of the sticky
wage model
A1: Long-term nominal wage contracts
(nominal rigidity).
A2: Firms observe P and have the
right-to-manage.
A3: Workers’ real wage target consistent with
full employment (no real rigidity).
A4: Workers’ do not observe P when the wage
contract is set and form rational
expectations about P.
Perfect
Nominal Rational
competi-
wage expecta-
tion
contract tion
Firms Union
Real
wage
target
Right-to-
manage Workers
The time line
Contract day shocks Contract day
time
Long-run equilibrium
Union’s expectations are fulfilled
and reflected in the wage contract, i.e.,
the real wage target has been achieved.
Real wage target consistent with
full employment
Long-run full employment
The natural level of output
Long-run
equilibrium
P=Pe
W
WC
N
Short-run equilibrium
Because of unanticipated events that
occur after the contract has been
signed, the rational price expectation is
not fulfilled.
Real wage target is not achieved
Employment below or above full employment
Deriving the short-run AS in the sticky
wage model
Pe>PC LAS
P AS(WC)
C PB B
A Pe=PA A
B PC C
N Y
NC NB YC YB
Pe
Why is the AS upwards sloping?
Union WC/P
overestimated WC set
above
price level “too” high
target
ND
Unanticipated reduced
reduction in
the price
Y
decreases
The aggregate supply curve
Natural
level of
output
Change in the
price level that was
unanticipated at
the “contract day”
Economic policy
AS1
P
AD1
AD0 AS0
Y
“crowding” out via
real money balances
(and/or wealth
effects)
New insights
• Systematic demand management policy can
affect output and employment in the short run,
but not in the long-run.
• The “time horizon” during which policy
“works” depends on how long it takes for
nominal contracts (sticky wage model) or
expectations (misperception model) to adjust.
• In addition to the determinants of effectiveness
known from the IS-LM model, the price level
now plays a role for the short-run effects.
Comparing the two models
Misperception models Sticky wage models
Market clearing Non-market clearing
Misperceptions about Long-term contracts
shocks (Nominal rigidities)
Expectations Staggered contracts
Full employment Full employment
Sticky down, less so up
LAS
Sticky up and
down
Stick down, but not up
What is next?
• Analyzing the business cycle in the AD-
AS model with a sticky wage.
The sticky wage model
Goal: Full
employment
Nominal wage
Contracts based on
contracts cover + price expectations at
extended periods
the “contract day”
of time
Due to events that was unanticipated at the
“contract day”, expectations will be wrong.
Short-run fluctuations in real GDP and
employment around full employment
The imperfect-information model
The Lucas supply curve
New classical supply curve
Two types
of shocks
LR Real wage
Productivity increased and
shocks labor supply
increases
LR Real wage
Nominal unchanged and 1-
price shocks labor supply
unchanged
The misperception model
Agents make
mistakes when
they try to predict the
state of the economy
Business cycle
fluctuations, i.e.,
Upwards
sloping deviations from the
AS natural level
of output