Lecture 9: A Keynesian Response: The Overlapping Contracts Model Reference: Fischer, S, "Long Term Contracts, , JPE, Feb 1977

Fischer points out that it is empirically reasonable to assume that various contracts, especially labour contracts, extend for periods longer than the time required for monetary (and perhaps also fiscal) policy to be changed. Given stickiness of the nominal wage, even anticipated demand-management policy can affect output. Fischer accepts the NC assumption of rational expectations. However, he does not accept the assumption of continuously-clearing labour markets, since he assumes long-term labour contracts. He takes the existence of such longterm contracts as a given empirical fact, and works out its implications, without trying to provide a micro-economic theory explaining why such contracts exist. He suggests,

however, that the transaction cost of frequent price setting and wage negotiations must be part of the explanation. In subsequent lectures, we will examine other theoretical explanations. Model: Each firm signs a 2-period contract with employees, but monetary policy can be changed every period. (T)he contract drawn up at the end of period t specifies nominal wages for periods (t + 1) and (t + 2). Assuming..that contracts are drawn up to maintain constancy of the real wage, we specify: (13)
t-i

wt = t-ipt , i = 1, 2

where w and p are the nominal wage and the price level (in logs). Equation nos. follow Fischer. (Note: some earlier equations of his deal with one-period contracts.) t-iwt is the wage to be paid in period t as specified in contracts drawn up at the end of (t - i), and tipt is the expectation of pt evaluated at the end

of (t i). The scale factor is set at 0 for convenience. He assumes two sets of overlapping wage contracts, so that i = 1 and i = 2 in equation (13) each refers to half the firms in the economy. Diagrammatically:-

Monetary policy at t: can respond to disturbances up to and including period t-1. Assuming a single price for output, aggregate supply of output given by: 1 s (14) y t = pt ( t 1 w t + t 2 w t ) + ut 2 thus, 2 s 1 (14) y t = ( pt t i pt ) + ut 2 i =1 where ut is the supply disturbance: 1 < 1. (6) ut = 1 ut 1 + t ,
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We also have a simple AD function: (5) y t = m t pt v t , where (7) v t = 2 v t 1 + t , 2 < 1

t and t are mutually and serially uncorrelated disturbance terms with 2 expectation 0 and finite variance 2 and respectively.
Lastly, we have the monetary rule (10) m t = a i ut i + bi v t i (implicit informational assumption). Note that (10) implies (11)
t 1 i =1 i =1

mt = mt

The model is now complete. Solution on the basis of RE: first, eliminate y t between equations (14) and (5), and take

expectation twice, once at the end of time t-2, and once at the end of time t-1:
pt = t 2 m t t 2 ( ut + v t ) 2 1 (16) t 1 pt = t 1 m t + t 2 m t 3 3 1 2 t 2 ( ut + v t ) t 1 ( ut + v t ) 3 3 Substitute these into the (14)=(5) equation, to yield 4 2 (17) 2 pt = m t + t 2 m t 3 3 1 ( ut + v t ) t 1 ( ut + v t ) 3 2 t 2 ( ut + v t ) 3

(15)

t 2

Substitute (15) (17) into (14) (18) y t =

mt t 2 mt 1 + ( ut v t ) 3 2 1 1 + t 1 ( ut + v t ) + t 2 ( ut + v t ) 6 3

Significance of first term on right-hand side. Next, from equations (6), (7), and (10), we have (19)
t 2 mt

= a1 1 ut 2 + a i ut i + b1 2 v t 2 + bi v t i
i=2 i=2

and

(20) m t t 2 m t = a1 ( ut 1 1 ut 2 ) + b1 (v t 1 2 v t 2 ) = a1 t 1 + b1 t 1 Equation (20) shows that m t can respond to t 1 and t 1 , which are not known at time t-2, when half the wage contracts were signed. Substituting (20) into (18) we obtain, finally: (21) 1 y t = [a1 ( ut 1 1 ut 2 ) + b1 ( v t 1 2 v t 2 )] 3 1 1 1 + ( ut v t ) + t 1 ( ut + v t ) + t 2 ( ut + v t ) 2 6 3

1 1 = ( t t ) + [ t 1 ( a1 + 2 1 ) 2 3 2 + t 1 (b1 2 )] + 1 ut 2
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Asymmetry in the above. From (21), we see that monetary policy parameters a 1 and b 1 affect y t even though monetary policy at time t is fully anticipated at time t-1. This is because, as indicated earlier, half the wages cannot, and monetary policy can, respond to t 1 and t 1 . From (21), Fischer calculates asymptotic variance of y, in his equation (22) (exercise). 2 2 is a function of 2 , , and other y 2 parameters. He shows that y is minimized when a1 = 2 1 (23) b1 = 2 Thus, the optimal rule involves accommodating real disturbances that tend to increase the price level, and counteracting nominal disturbances that tend to increase the price level.

Fischer also points out that monetary authorities cannot exploit their leverage excessively, otherwise contracts likely to be changed.