Aggregate Dynamics and Staggered Contracts

Staggered wage contracts as short as 1 year are shown to be capable of generating the type of unemployment persistence which has been observed during postwar business cycles in the United States. A contract multiplier causes business cycles to persist beyond the length of the longest contract, and a diffusion of shocks across contracts causes the persistence to increase for several periods before diminishing. A persistence of inflation is also generated by the contracts. This persistence is represented as a reduced-form distributed-lag wage equation in which the lag coefficients have a pure-expectations component and an inertia component due to the overhang of outstanding contracts. Using rational expectations to separate these components suggests that aggregate demand may have a greater impact on inflation than the simple reduced-form estimates would indicate.