When Should Labor Contracts Be Nominal?

By Antoine Martin and Cyril Monnet
September 2001 
RWP 01-07
Research Division 
Federal Reserve Bank of Kansas City 

Abstract

We propose a theory to explain the choice between nominal and indexed labor contracts. We find that contracts should be indexed if prices are difficult to forecast and nominal otherwise. Our analysis is based on a principal-agent model developed by Jovanovic and Ueda (1997) in which renegotiation can take place once the nominal value of the agent's output is observed. Their model assumes that agents use pure strategy, with the strong result that only nominal contracts can be written without being renegotiated. But, in reality, we do observe indexed contracts. We resolve this weakness of their model by allowing agents to choose mixed strategies, and find that the optimal contract is indeed nominal for certain parameters. For other parameters, however, we show that the optimal contract is indexed. Our findings are consistent with two empirical regularities:   that prices are more volatile with higher inflation, and that countries with high inflation tend to have indexed contracts.

Keywords: Nominal Contracts; Theory of Uncertainty and Information

JEL classification: D8, E3, J4

Antoine Martin is an economist at the Federal Reserve Bank of Kansas City.  Cyril Monnet is an economist at the European Central Bank.  This paper is part of the authors' Ph.D. thesis from the University of Minnesota.  Part of it was written while the authors were visiting the Federal Reserve Bank of Minneapolis.   The authors would like to thank Ed Green, Larry Jones, Narayana Kocherlakota, Thor Köppl, and Masako Ueda for helpful comments and suggestions.  The authors also thank Matthew Cardillo for providing valuable research assistance.  The views expressed in this paper are solely those of the authors and do not necessarily reflect those of the European Central Bank, the Federal Reserve Bank of Kansas City, the Federal Reserve Bank of Minneapolis, or the Federal Reserve System. 

Martin email:  antoine.martin@kc.frb.org
Monnet email: cyril.monnet@ecb.int

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