THE ECONOMETRICS OF MACROECONOMIC MODELLING

Wage bargaining and. price-setting

In this chapter we go a step forward to compare both the main-course model and the Phillips curve by introducing the Layard-Nickell wage - curve model of incomplete competition. It marks a step forward in that it combines formal models of wage bargaining and models of monopolistic price-setting. Thus, compared to Aukrust’s model, the hypothesised wage and price cointegrating vectors are better founded in economic theory, and, specific candidates for explanatory variables flow naturally from the way the bargaining model is formulated,. We will show that there are cases of substantiae interest where the identification problem pointed out by Man­ning (1993) are resolved, and we will show applications with empirically stable and interpretable wage and price curves.

5.1 Introduction

In the course of the 1980s interesting developments took place in macro­economics. First, the macroeconomic implications of imperfect competition with price-setting firms were developed in several papers and books; see, for example, Bruno (1979), Bruno and Sachs (1984), Blanchard and Kiyotaki (1987), and Blanchard and Fisher (1989: ch. 8). Second, the economic theory of labour unions, pioneered by Dunlop (1944), was extended and formalised in a game theoretic framework; see, for example, Nickell and Andrews (1983), Hoel and Nymoen (1988). Models of European unemployment, that incorp­orated elements from both these developments, appeared in Layard and Nickell (1986), Carlin and Soskice (1990), Layard et al. (1991), and Lindbeck (1993). The new standard model of European unemployment is incontestably linked to Layard and Nickell and their co-authors. However, we follow established prac­tice and refer to the framework as the Incomplete Competition Model (ICM),

or, interchangeably, as the wage curve framework (as opposed to the Phillips curve model of the previous chapter). Incomplete competition is particularly apt since the model’s defining characteristic is the explicit assumption of imper­fect competition in both product and labour markets, see; for example, Carlin and Soskice (1990).[30] The ICM was quickly incorporated into the supply side of macroeconometric models (see Wallis 1993, 1995), and purged European econometric models of the Phillips curve, at least until the arrival of the New Keynesian Phillips curve late in the 1990s (see Chapter 7 in this book).

Since the theory is cast in terms of levels variables, the ICM stands closer to the main-course model than the Phillips curve tradition. On the other hand, both the wage curve and the Phillips curve presume that it is the rate of unem­ployment that reconciles the conflict between wage earners and firms. Both models take the view that the equilibrium or steady-state rate of unemployment is determined by a limited number of factors that reflect structural aspects such as production technology, union preferences, and institutional factors (charac­teristics of the bargaining system, the unemployment insurance system). Thus, in both families of theories demand management and monetary policy have only a short-term effect on the rate of unemployment. In the (hypothetical) situation when all shocks are switched off, the rate of unemployment returns to a unique structural equilibrium rate, that is, the natural rate or the NAIRU. Thus, the ICM is unmistakably a model of the natural rate both in its motivation and in its implications: ‘In the long run, unemployment is determined entirely by long-run supply factors and equals the NAIRU’ (Layard et al. 1994, p. 23).