Incomplete Capital Markets, Wage Formation and Stabilization Policy

The future purchasing power of wage income may become risky in the presence of capital market imperfections. Current nominal wages therefore have intertemporal implications which in turn affect wage determination. The influence of consumption risk on wage setting is analysed in a general equilibrium model with an imperfectly competitive labour market (monopoly union). It is shown that the adjustment process implies wage smoothing and nominal rigidities. Nominal wages are less flexible than prices and there is more persistency in wage than in price adjustment. Moreover employment shows more variability over the business cycle than real wages no matter whether the cycle is driven by supply or demand shocks. An active demand management policy is shown to affect risk and, therefore, real allocations and to be potentially Pareto improving.