DP2407 | Monetary Institutions, Monopolistic Competition, Unionized Labour Markets And Economic Performance

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Existing literature on the strategic interaction between the central bank (CB) and unions assumes that firms face perfect competition on product markets and that inflation is chosen directly by the monetary authority. Although these simplifications have the virtue of making complex strategic interactions more tractable, they abstract from the fact that, in reality, prices are set by firms and that the monetary authority affects the price level and inflation by determining the money supply. This paper makes a step in the direction of realism by recognizing that prices are set by monopolistically competitive firms and that the monetary authority affects the price level and inflation indirectly through its choice of money supply. This is done in a three stage game, in the first stage of which unions contractually set nominal wages, in the second stage the CB chooses the money supply, and in the third stage each firm chooses its individually optimal price. A sample of the paper's results follows: 1. In spite of full price flexibility, changes in the degree of conservativeness of the CB affect employment and output even when inflation is fully anticipated by labour unions and even when unions are indifferent to inflation. 2. When the CB is sufficiently conservative it reduces the money supply in response to wage increases. Both casual and econometric evidence suggests that such a mechanism has been operating in Germany where the Bundesbank often tightened monetary policy in response to 'excessive' wage settlements. 3. Recent results concerning the optimality of a populist or 'ultra-liberal' CB are shown to be the exception rather than the rule. In particular, in many circumstances, an ultra conservative CB reduces both inflation and unemployment sufficiently to make the appointment of such a bank socially optimal. Intuitively, when the CB is more conservative each union correctly anticipates a stronger contractionary reaction to an increase in its wage and, therefore, a stronger increase in unemployment among its members. As a consequence, the deterring effect of unions' fear from unemployment on their wage demands is stronger and employment higher when the CB is more conservative.