Endogenous unions and governments: A game-theoretic approach

Abstract

This paper applies some elements of game theory to the determination of government spending and wages within a simple macroeconomic framework where these variables are ordinarily treated as exogenous in the short run. By showing how nominal wages respond to increased government spending and taxes and vice versa, the paper attempts to explain the simultaneous tendency of many Western economies toward persistent inflation and expansion of the public sector. In particular, the paper stresses the macroeconomic consequences of the interaction between endogenous utility-maximizing governments and labour unions, and shows how the response of the economy to changes in government and union behaviour depends on the preferences of both parties with respect to inflation, employment, real disposable wages, and government spending as well as on their view of the relative magnitude of the employment and price effects of such changes.