Financial Policy Working Papers

Contract Multiplier Revisited: Solving the Persistence Problem in a Model with Staggered Contracts

Banking and Policy Working Paper 1-03 (This draft: February 2003; Second draft: March 2002; First draft: November 2000)

Jangryoul Kim

Published February 1, 2003

In a standard dynamic stochastic general equilibrium model with deterministic price staggering, Chari, Kehoe, and McGrattan (1998) find that staggered price contracts in the spirit of Taylor (1979,1980) cannot generate persistence in real effects of monetary disturbances. This paper reconsiders the ability of staggered contracts to generate persistent effects of monetary disturbances. In a model with price and wage contracts in the spirit of Calvo (1983), I demonstrate that the “contract multiplier” is generated by nominal rigidities in both labor and goods markets. Other features of business cycles, such as the hump-shaped responses of output, real wage acyclicality, and the persistence in inflation rate are also well explained by the model. Calibration exercises and analytical solutions of stripped-down versions of the model suggest that wage stickiness is more effective in generating persistence, since it directly controls the marginal cost of firms and thereby dampens the incentive for firms to raise prices after expansionary monetary shocks. Comparing stochastic and deterministic staggered contracts, I find that the oscillatory responses (hence, no persistence) in output in CKM is due to a counterintuitive nuisance feature of deterministic staggered price contracts (i.e., the initial overshooting of prices reset after monetary disturbances), and that, free of such nuisance feature, stochastic staggering is in principle capable of generating persistence even if marginal costs are highly procyclical.