Unexpected Inflation, Real Wages, and Employment Determination in Union Contracts David Card The American Economic Review, Vol. 80, No. 4. (Sep., 1990), pp. 669-688. Stable URL: http://links.jstor.org/sici?sici=0002-8282%28199009%2980%3A4%3C669%3AUIRWAE%3E2.0.CO%3B2-V The American Economic Review is currently published by American Economic Association. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/about/terms.html. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/journals/aea.html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. The JSTOR Archive is a trusted digital repository providing for long-term preservation and access to leading academic journals and scholarly literature from around the world. The Archive is supported by libraries, scholarly societies, publishers, and foundations. It is an initiative of JSTOR, a not-for-profit organization with a mission to help the scholarly community take advantage of advances in technology. For more information regarding JSTOR, please contact [email protected]. http://www.jstor.org Mon Jul 2 13:58:03 2007 Unexpected Inflation, Real Wages, and Employment Determination in Union Contracts This paper examines the effect of nominal contracting provisions on employment determination in union contracts. In most contracts the nominal wage" rate is wholly or partially predetermined. Real wage rates therefore contain unanticipated components that reflect unexpected price changes and the degree of indexation. The empirical analysis, based on a large sample of indexed and nonindexed contracis, suggests that unexpected real wage changes are associated with system- atic employment responses in the opposite direction. I conclude that nominal contracting provisions play a potentially important role in the cyclical properties and persistence of employment movements in the union sector. (JEL 130,820) What role do nominal wage contracts play and empirical performance of nominal con- in the determination of employment and tracting models. One the one hand, there the characteristics of the business cycle? An are as yet no convincing theoretical expla- influential series of papers by Stanley Fis- nations for the existence of nominally fixed cher (1977), Edmund S. Phelps and John B. contracts. Many of the models developed Taylor (1977), and John B. Taylor (1980) over the past decade predict constant real argued that fixed wage contracts create a wages or constant real earnings.' On the link between employment and aggregate de- other hand, the evidence in support of nom- mand. More recent models of macro fluc- inal contracting models is also weak. The tuations stress other channels for the trans- simplest of these models asserts that aggre- mission and persistence of aggregate shocks. gate demand shocks lead to real wage Real business cycle models (for example, changes that induce movements along a Finn E. Kydland and Edward C. Prescott, downward-sloping demand schedule. Al- 1982) assume that supply and demand in though unanticipated price increases are the labor market are equilibrated at Wal- apparently correlated with real economic rasian levels and ignore the institutional activity (see the review by Jo Anna Gray structure of wage determination. Recent and David Spencer, forthcoming), the ab- models in the Keynesian tradition, on the sence of a clear negative correlation be- other hand, have shifted attention from tween aggregate employment and real wages nominal wage rigidities to real wage rigidi- (Patrick T. Geary and John Kennan, 1982) ties (for example, Olivier J. Blanchard and poses a serious challenge to models of nom- Lawrence H. Summers, 1986) or nominal inal wage rigidity. price rigidities (for example, N. Gregosy This paper presents new evidence on the Mankiw, 1985; Olivier J. Blanchard and consequences of nominal contracting provi- Nobuhiro Kiyotaki, 1987). sions for employment determination in the This shift in interest reflects dissatisfac- unionized sector of Canadian manufactur- tion with both the theoretical underpinnings ing. The analysis, based on data for 1300 *Department of Economics, Princton University, 'see the survey of implicit contracting models by Princeton, NJ 08540. I am grateful to Robert Hall, Sherwin Rosen (1985). A concise summary of the im- Robert King, and two referees for their comments on plications of these models from a macroeconomic per- earlier drafts. Thomas Lemieux and Sara Turner pro- spective is presented by Stanley Fischer (1987, pp. vided expert assistance in data preparation. 42-50). 670 THE AMERICAN ECONOMIC REVIElY SEPTE,bIBER 1990 indexed and non-indexed contracts written the staggering of expiration dates also make between 1966 and 1982, suggests that nomi- it possible to control for aggregate-level dis- nal contracting provisions play an important turbances that affect all contracts at a point role in the link between aggregate demand in time. Second, the analysis pays special and employment. As predicted by the sim- attention to the issue of endogenous wage ple models of Fischer (1977) and Jo Anna determination.' Even in a simple Fischer- Gray (1976), I find that real wage changes Gray contracting framework this is a poten- induced by aggregate price surprises lead to tially serious problem, insofar as the bar- systematic employment responses in the op- gaining parties have information on future posite direction. Unexpected real wage employment demand that is unavailable to changes also affect subsequent wage deter- an outside data analyst. If predictable com- mination: the empirical results suggest that ponents of future employment demand af- roughly one-third of such changes carry over fect wages, they create a simultaneity bias in to the following contract. Unanticipated ordinary least-squares estimates of the elas- price increases therefore generate short-run ticity of employment with respect to real- employment responses and persistent wage ized wage rates. changes among firms in the union sector. To solve this problem I use the unex- Two features of the empirical analysis pected component of real wages as an in- distinguish these results from eariier at- strumental variable for the level of wages. tempts to measure the effects of nominal By assumption, unexpected changes in real wage rigidities. First, the analysis is based wages are correlated with wages but uncor- on individual contract data rather than ag- related with information known at the nego- gregate or industry-level data.2 Since union tiation date of the contract. Unexpected contracts differ in their negotiation dates wage changes therefore form a valid instru- and degrees of indexation, it is possible to mental variable for a structural analysis of calculate contract-specific measures of un- employment demand. This procedure also expected price increases and unexpected provides a direct test of the role of nominal real wage changes, and to estimate the sep- wage rigidities in generating employment arate effects of price surprises and real wage responses to nominal shocks. The instru- surprises. Variation in contract lengths and mental variables estimate of the elasticity of labor demand is nonzero if and only if em- ployment is correlated with unexpected real wage changes. The empirical results confirm the value of 'MUC~ of the earlier literature on nominal contract- this approach. In ordinary least-squares re- ing models focuses on their implications for aggregate gressions, changes in employment are only price and wage dynamics: see Taylor (1980) and Orley weakly related to changes in contract wages. Ashenfelter and David Card (1982). A recent study by When unexpected real wage changes are Shaghil Ahmed (1987) correlates the degree of wage flexibility in an industry, measured by the elasticity of used as an instrumental variable, however, indexation among indexed labor contracts, with the employment is found to be systematically slope of the industry-specific Phillips curve. Ahmed's negatively related to wages. This finding measure of wage flexibility is based on a sample of only continues to hold when unexpected price 98 contracts in 20 industries. and fails to take into changes are added directly to the employ- account any of the characteristics of the nonindexed contracts in an industry. Furthermore, his measure of ment demand equation. It is also robust to flexibility only pertains to workers in large union con- the addition of unrestricted dummy vari- tracts and ignores variation across industries in the extent of unionization or the share of large firms. Thus, I do not interpret his findings as strong evidence for or against the hypothesis that nominal contract rigidities are important. The approach taken by Mark Bils (1989) '~ohnKennan (1988) presents an illuminating analy- is perhaps most similar to that in this paper. He sis of the difficulties that arise in the interpretation of compares the variability of industry employment growth aggregate employment and wage data when the data in months with a significant number of contract negoti- are generated by a simple model of demand and sup- ations to the variability in other months. ply. VOL.80 NO. 4 CARD: EMPLOYMENT DETERMINATION IN UNION CONTRACTS 671 ables representing each year of the sample. of the contract and whether or not it con- I conclude that nominal wage contracts play tains a cost-of-living escalation clause.' an important role in determining the cycli- Assume that n(t) is determined by an cal properties and persistence of employ- employment demand schedule of the form ment in the union sector. I. Employment and Wages in a Simple Contract Model where ~(t)is a vector of observable vari- ables shifting the demand for labor, @ rep- A.