State Dependency in Price and Wage Setting

Abstract

The frequency of nominal wage adjustments varies with macroeconomic conditions, but existing models exclude such state dependency in wage setting and assume constant frequency under time-dependent setting. This paper develops a New Keynesian model in which fixed wage-setting costs generate state-dependent wage setting. I find that state-dependent wage setting reduces the real impacts of monetary shocks compared to time-dependent setting. However, when parameterized to reproduce the fluctuations in wage rigidity in the U.S., the state-dependent wage-setting model generates responses to monetary shocks similar to those of the time-dependent model. The trade-off between output gap and inflation variability is also similar between these two models.