Nominal-Wage Contracts and Real Activity: Evidence from the German Economy

Abstract

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 nominalwage contracting variety explanation of Fischer [4] and Gray [7], and the equilibrium explanation of Lucas [11].' 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