Nominal wage contracts and the persistent effects of monetary policy

Abstract

We consider an efficiency wage model where wages affect turnover and firms choose optimal labor contracts under uncertainty about demand and productivity. We show that there may be an equilibrium with nominal wage contracts where monetary shocks affect output. Furthermore, monetary shocks have persistent effects on output because the previous state of the labor market affects the reemployment probability of quitting workers. Persistence increases if workers have bargaining power. With endogenous policy, a credibility problem arises naturally in the model. Equilibrium inflation increases with persistence but decreases with the natural rate of unemployment for given persistence.