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# Nominal wage rigidities in an optimizing model of an open economy

DOI link for Nominal wage rigidities in an optimizing model of an open economy

Nominal wage rigidities in an optimizing model of an open economy book

# Nominal wage rigidities in an optimizing model of an open economy

DOI link for Nominal wage rigidities in an optimizing model of an open economy

Nominal wage rigidities in an optimizing model of an open economy book

## ABSTRACT

Since the seminal articles of Kydland and Prescott (1982) and Long and Plosser (1983), researchers have attempted to put both closed-and open-economy macroeconomic models on firmer microfoundations. Dynamic general equilibrium (DGE) models have had some success in explaining the properties of business cycles in closed and open economies. Models which incorporate nominal wage and/or price rigidities have had success in explaining certain features of the data, such as the co-movements between nominal and real variables and the large and persistent responses of output and other real variables to monetary shocks.1 The pioneering paper by Obstfeld and Rogoff (1995) developed an open-economy optimizing model with nominal price rigidities that was able to explain large fluctuations in real exchange rates in response to monetary shocks. Other recent papers such as Beaudry and Devereux (1995), Chari et al. (2002), and Kollmann (2001) have extended the analysis of Obstfeld and Rogoff (1995). In particular, the papers by Chari et al. (2002) and by Kollmann (2001) evaluate the quantitative impact of nominal rigidities on the persistence of real exchange rate fluctuations. Both papers construct dynamic open-economy models that are calibrated and subjected to stochastic simulations.2 Chari et al. (2002) show that the observed degree of real exchange rate persistence can be explained only by supposing that firms change their prices at implausibly long intervals. Kollmann (2001) builds a model with both nominal price rigidities and nominal wage rigidities. He shows that if prices are adjusted by firms and wage contracts are renegotiated on average every 12.5 quarters, real exchange rate fluctuations are as persistent as in the data, as measured by the first-order autocorrelation coefficient. Kollmann (2001) cites evidence by Rotemberg (1982b) that this frequency of price adjustment is compatible with the data, but it falls in the range of what Chari et al. (2002) term “long stickiness,” a frequency of price adjustment that is lower than their base-case scenario. This chapter shows that of the two types of nominal rigidities, nominal wage

rigidities are crucial in leading to persistent fluctuations of exchange rates and other real variables. We build a model in which wage setting by monopolistically competitive households is the only source of nominal rigidity. The model also includes

additional dynamic propagation mechanisms such as capital accumulation and an endogenous domestic real interest rate. We show that if wages are adjusted by wage setters every four quarters on average, the model generates almost as much real exchange rate persistence as the Kollmann (2001) model, as much nominal exchange rate persistence, and output fluctuations that are slightly more persistent than in the data. Our model generates almost as much real exchange rate volatility as theKollmann (2001)model, which is considerably higher than the real exchange rate volatility produced by the model of Backus et al. (1994), a model with flexible wages and prices. We interpret these results by examining the incentives for wage setters to adjust their nominal wages in our model, and comparing these to the incentives of firms to adjust their prices both in models with price rigidity alone and in models with both nominal wage and nominal price rigidity. Our results confirm and extend results from closed-economy business cycle

models on the relative roles of wage rigidity and price rigidity in explaining the persistent fluctuations of real variables. Chari et al. (2002) and Huang and Liu (2002) have questioned the ability of models with nominal price rigidities alone to explain persistence. They show that when firms are allowed to adjust their prices, they make large adjustments that rapidly neutralize the effects of shocks to aggregate demand. In order for monetary shocks to have persistent effects, either price adjustment must be very infrequent or the size of firms’ price adjustment must be made small by introducing what are known as real rigidities, so that optimal prices are relatively insensitive to fluctuations in aggregate demand. Possible sources of real rigidities include increasing returns to scale and intermediate inputs that represent a significant fraction of production costs. Both of these features have the effect of flattening firms’ marginal cost curves. Huang and Liu (2002) show that it is easier to generate persistence with a small degree of nominal wage stickiness, and without introducing real rigidities. Ambler (2002) shows that it is possible to support nominal wage rigidities as an equilibrium outcome in a standard business cycle model with modest and plausible fixed costs of adjusting wages. The rest of the chapter is organized as follows. In Section 3.2, we present the

details of the model. In Section 3.3, we discuss its solution. Section 3.4 deals with the calibration of the model’s structural parameters. We present our main results in Section 3.5, and our conclusions in the last section.