Publication: International Advances in Economic Research
Publication Date: 01-MAY-07
Delivery: Immediate Online Access
Author: Calmes, Christian
Article Excerpt
Abstract To properly account for the dynamics of the key macroeconomic variables, researchers incorporate various internal propagation mechanisms in their models. In general, these mechanisms implicitly rely on the assumption of a perfect equality between the real wage and the marginal product of labour. This paper features a micro-founded model of a limited-commitment firm, and derive endogenous dynamic labour contracts that produce a different linkage between the real wage and the marginal product of labour. The risk-sharing between the entrepreneur and the worker, both faced with enforcement problems, provides a different type of propagation mechanism. I investigate the dynamic properties of this endogenous rigidity in relation to the initial bargaining power of each agent.
Keywords internal propagation mechanisms * real business cycle * risk-sharing hypothesis
JEL E12 * E49 * J30 * J31 * J41
Introduction
The motivation of this paper comes from two well-known shortcomings of the macroeconomic literature. On the one hand, some Real Business Cycle (RBC) models have insufficient internal propagation mechanisms. They have difficulties in replicating some key elements of the economy's dynamics. For example, they sometimes fail to completely replicate the observed permanent and transitory characteristics of the impulse-response functions of output, and the observed persistence of output growth (Cogley & Nason, 1995). On the other hand, despite some partially successful attempts, some RBC models also have trouble explaining the aggregate wage dynamics we observe in the data (e.g., the discrepancy between wage and the marginal product of labour, mpl).
In other respects, Beaudry and DiNardo (1995) note that the deviation between the wage and the mpl is at odds with the flexible wage model, but consistent with contracting models. For instance, implicit wage contracts models a la Azariadis (1975), Baily (1974), and Gordon (1974) (ABG hereafter) have already been shown to be relatively effective in generating wage stickiness (Hart & Holmstrom, 1987). This article features a theoretical framework based on this type of contracts. However, the ABG models describe full-commitment allocations; instead, I consider a two-sided limited-commitment economy featuring self-enforcing contracts. These contracts are characterized by an imperfect risk-sharing due to the existence of a limited-commitment problem, where the relationship's continuation is subject to the constraint that no agent is better off taking advantage of an external opportunity. Compared to Thomas and Worral (1988), the paper also provides a numerical computation of contracts specifying the wage and the hours worked, and a study of their implications for macroeconomic dynamics.
The endogenous self-enforcing contracts are used to analyze the implied dynamics of labour and consumption, and to examine to what extent this macroeconomic dynamics differs from the one implied by a flexible wage model. The proposed model generates an endogenous real rigidity coming from the income insurance provided by the risk-sharing hypothesis. It is shown that this rigidity constitutes a promising propagation mechanism. The second section delivers the intuition about using self-enforcing contracts. The third section defines the theoretical framework and provides an explanation of the underlying dynamic bargaining game. The fourth section fully describes the limited-commitment economy. It includes some basic results aiming at characterizing the contracts and the properties of the economy's dynamics. The following section explains the numerical computation of the limited-commitment economy, defines the recursive self-enforcing equilibrium and details some key numerical results. The last section concludes.
Why Rely on the Risk-Sharing Hypothesis?
There are several attractive features associated with the risk-sharing hypothesis. First, it provides an explicit microeconomic foundation for a specific form of wage stickiness. In this type of contract models, the stickiness is an artifact of the risk-sharing hypothesis. Furthermore, the dynamic properties that this hypothesis adds to the models are not dependent on the preference specification (Rosen, 1985). For example, the results in Kydland and Prescott (1982) and Hansen (1985) among others, rely on precise assumptions about preference. Au contraire, one advantage of using implicit of contracts is that they constitute a potential internal propagation mechanism compatible with a wide range of utility functions.
Since the paper focuses on macroeconomic dynamics, the implicit labour contracts theory provides yet another, more attractive, feature. The contract insures the worker against fluctuations caused by the shocks (Hart & Holmstrom, 1987). For this reason, the income effect, that arguably plays a neutralizing role in the flexible wage models, is reduced by the risk-sharing. Indeed, the income transfers through states permitted by the risk-sharing device allows workers to be almost unconcerned by the variability of consumption. In other words, only the (opportunistic) substitution effect may play its role fully.
In that case, two important corollaries follow. First, even if there were savings in the model, hours could still be quite volatile. In that respect, the risk-sharing hypothesis provides a plausible alternative to the intertemporal substitution hypothesis. Second, despite being smoothed, consumption can be more volatile than in regular models because it is tied to hours. These two appealing corollaries come from the fact that the insurance device operates a consumption smoothing over time and over states. Consequently, in such a framework, unless one relies on extremely separable preferences, it is theoretically possible to get consumption and hours potentially more volatile than in the standard case (Calmes, 2003). The introduction of the risk-sharing at the core of the worker-entrepreneur relationship...
NOTE: All illustrations and photos have been removed from this article.
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