Research Discussion Paper – RDP 8611 The Effectiveness of Fiscal Policy in an Economy with Anticipatory Wage Contracts
August 1986
Abstract
This paper studies an economy where the labour market does not necessarily clear because real wages are sticky. Wages are fully indexed to prices, and are optimally adjusted over time in response to steady state deviations of output and of inflation. Inflation deviations will arise if wage setters make contracts that take into account long term forces, fulfilling a “social contract”. When fiscal policy drives a wedge between long run and current inflation, it can have supply-side effects.
If goods markets always clear and future inflation is perfectly foreseen, fiscal policy can have real supply-side effects. With only money finance, such effectiveness exists only if the economy has sufferred from an exogenous supply shock. If debt shares in the finance of fiscal deficits, real effects can be created even if the system is in steady state. The direction of the effects depend upon the extent to which fiscal policy is endogenised on account of the implied debt service. A fiscally cautious government will create net output gains after an expansion.
If goods markets do not clear, and the price level (but not inflation) is sticky, supply-side fiscal policy can only operate in a Classical Unemployment region. In this region, fiscal expansion only affects inflation, and output is perpetually stuck.