Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule

Abstract

The paper is concerned with the role of monetary policy and argues that activist monetary policy can affect the behavior of real output, rational expectations notwithstanding. A rational expectations model with overlapping labor contracts is constructed, with each labor contract being made for two periods. These contracts inject an element of short-run wage stickiness into the model. Because the money stock is changed by the monetary authority more frequently than labor contracts are renegotiated, and, given the assumed form of the labor contracts, monetary policy has the ability to affect the short-run behavior of output, though it has no effects on long-run output behavior.