Centralised Wage Setting, Inflation Contracts, and the Optimal Choice of Central Banker

Abstract

The paper examines the appropriate design of central banking institutions in an economy in which the nominal wage is set by an inflation-averse monopoly union as a positive mark-up over its market-clearing value. The analysis considers both the optimal choice of central banker and the potential role for a linear inflation contract. The optimal set of arrangements is a central banker who attaches less significance to inflation than does society, combined with an inflation contract where the value of the contract parameter is related to the union's degree of inflationaversion. Following the important contribution of Rogoff (1985), the appointment of a 'conservative' central banker has been widely accepted as a potential (albeit partial) solution to the time inconsistency problem associated with discretionary policy making. In placing a greater weight on inflation than does the government (and society as a whole) in the setting of monetary policy, the central bank's temptation to create inflation surprises is reduced. This then leads to a lower inflation rate in equilibrium than would otherwise prevail. Whilst in Rogoff's stochastic framework this reduction in the inflationary bias has to be weighed against an increase in output variability, the appropriate choice of central banker ensures a net improvement in welfare. An important feature of Rogoff's model is the assumption of an atomistic labour market in which nominal wages, embodied in single-period contracts, reflect interaction between agents who hold no market power. Such a representation of the labour market also characterises most subsequent extensions of Rogoff's analysis, e.g. Lohmann (1992) and Waller (1992). However, a number of recent papers, in considering the time inconsistency issue, have employed the assumption of unionised wage setting, assuming either an allencompassing monopoly union or, alternatively, a number of individual unions each of which has a non-negligible impact on macroeconomic variables. Examples include; Agell and Ysander (1993), Bleaney (1996), Cubitt (1992, 1995), Horn and Persson (1988), Hutchison and Walsh (1998) and Skott (1997). These contributions have examined the implications of the assumed labour market imperfection from a variety of perspectives but only those of Bleaney and Skott directly consider its consequences for the appropriate specification of central bank objectives. In what follows, we explore the significance of unionised wage setting for