Central Bank: The Underlying Economy

The closest paper in the literature is the recent one by Cukierman and Lippi (1998), which was written simultaneously with this one. They also consider a monetary policy game with many unions, and study the interaction among labor market centralization, and economic performance. The main difference is that they work with an ad-hoc model with the crucial assumption that the elasticity of substitution among the labor supplied by different unions is always increasing in the number of unions, and goes to infinity as the number of unions goes to infinity.

By contrast, we work with a micro-founded model which yields very different implications for the relationship between the number of unions and the elasticity of labor demand. These modelling differences matter a great deal in terms of results. Cukierman and Lippi (1998) reproduce the conventional wisdom that economic performance is U-shaped in the number of unions, and therefore an intermediate degree labor market centralization is worst. We find that, depending on parameter values, the opposite results obtain: economic performance is either always decreasing or U-shaped in the number of unions; in the latter case, an intermediate degree labor market centralization is best.

Empirically there is some preliminary evidence for some of the interactions among CBC, CWS and economic performance that we predict here. For instance, Hall and Franzese (1996) find that in economies with a highly centralized labor market higher CBC increases unemployment -very much in contradiction with the conventional wisdom alluded to at the outset. Bleaney (1996) finds higher that average inflation is (weakly) associated with higher CWS, even after controlling for CBC.

The paper is organized as follows. Section 2 presents the basic model, and section 3 computes the equilibrium of the relevant game. Section 4 examines the implications of the equilibrium for government policy and the optimal structure of the labor market, while section 5 concludes.

The Underlying Economy

The economy is populated by a single representative firm that produces the single consumption good, and a continuum of symmetric workers (indexed by i and arranged in the unit interval) who supply labor, receive dividends from the firm, and consume. Workers are organized in n > 2 unions (indexed by j)) each of which has a set of members of measure пГ1 on whose behalf it sets wages. There is also a government, which sets the rate of inflation and hence affects real wages.

The firm

The representative firm produces output using labor from the different unions. The firm behaves competitively, taking wages as given. Its technology is given by
where Yt is the representative firm’s output, Lt (i) is labor input from agent г, and n is the number of unions. The parameter a is the elasticity of substitution among the different types of labor supplied by agents, and a is a returns to scale parameter.5 Notice that if all Lt (г) are the same, then Yt = Lt (i)a.