Aggregate Dynamics and Staggered Contracts

TLDR

The authors model wage persistence with a reduced‑form distributed‑lag equation whose coefficients capture pure expectations and contract inertia. Staggered wage contracts as short as one year generate unemployment and inflation persistence beyond the contract length, with a contract multiplier extending cycles and shock diffusion amplifying persistence for several periods before fading, and rational‑expectations analysis indicates aggregate demand may influence inflation more than reduced‑form estimates suggest.

Abstract

Staggered wage contracts as short as 1 year are shown to be capable of generating the type of unemployment persistence which has been observed during postwar business cycles in the United States. A contract multiplier causes business cycles to persist beyond the length of the longest contract, and a diffusion of shocks across contracts causes the persistence to increase for several periods before diminishing. A persistence of inflation is also generated by the contracts. This persistence is represented as a reduced-form distributed-lag wage equation in which the lag coefficients have a pure-expectations component and an inertia component due to the overhang of outstanding contracts. Using rational expectations to separate these components suggests that aggregate demand may have a greater impact on inflation than the simple reduced-form estimates would indicate.