Central Bank: Introduction 3

More specifically, the model below has the following implications for the relationship among CBC, CWS and macroeconomic performance.

The conventional wisdom that discretionary policymaking yields an inflation bias while leaving employment and output at suboptimal levels, relies on two special assumptions:

a) unions are myopic (they do not internalize the consequences of their actions);

b) unions suffer no costs from inflation.

If either of those is adopted, our model yields precisely the standard results.

For a fixed number of unions, a radical-populist central banker, who cares not at all about the costs of inflation, maximizes the welfare of the population by delivering zero inflation and optimal employment and output levels.

For a fixed number of unions, employment and output fall as CBC increases. This occurs because each union realizes that the inflationary consequences of raising its wage fall as CBC rises, and hence engage in more aggressive wage-setting in equilibrium.

For a fixed number of unions, inflation is inverted-U-shaped in the degree of CBC. This is because higher CBC enlarges the inflation bias (as we saw in (3) above), but also the central bank’s determination to fight this bias.

For a fixed and sufficiently large number of unions, a moderately conservative central bank delivers the lowest welfare levels. This follows directly from (3) and (4) above: a little bit of CBC increases inflation while reducing employment: it takes a lot of CBC for inflation to fall, and hence for welfare to increase.

For a given level of CBC, if the elasticity of substitution among different types of labor is sufficiently small, then economic performance and welfare are uniformly decreasing in the number of unions. For larger values of this elasticity, economic performance and welfare are hump-shaped in the number of unions (which we take as a proxy for the degree of decentralization of wage setting), and there is an intermediate degree of decentralization that maximizes economic performance and welfare.

Some discussion of the previous theoretical literature, and how our work differs from it, is warranted. The links among CBC, the structure of the labor market and economic performance have been analyzed formally before. The paper by al Nowaihi and Levine (1994) was the first to study the behavior of a single union that does care about inflation, but did not tackle the issues studied here. Cubbit (1997) considers a monetary policy game between a central bank and a single union; thus, he cannot explore the implications of varying degrees of CWS. Bleaney (1996) does incorporate a variable number of unions, but they are assumed not to care about inflation.

In none of these models can the connection among different degrees of CBC, labor market centralization and economic performance be properly studied. Finally, Gruner and Hefeker (1998) study the effects of EMU in a setup with many countries, each of which contains one union which cares about inflation; the model in that paper could potentially yield results similar to ours concerning the role of CBC, but the focus there is entirely different.