QUEST II. A Multi-Country Business Cycle and Growth Model



:DJH &RQWUDFWV

In the above derivation of the wage equation it was assumed that workers and firms
negotiate a wage contract every period (quarter). However, wage contracts usually stretch
over more periods, very often over one year. Therefore in the model it is assumed that each
quarter a fraction of the employees enter wage negotiations for a contract over several
periods. A wage contract is set which is a weighted average of the current and
1
consecutive one period contracts which are based on current expectations on labour market
conditions prevailing in these
1 consecutive periods. Denote the nominal wage from the one
period Nash bargaining solution by
:, then the current wage contract can be written as

N-I 1

wcont, =∑ - (, (: (1)+ 3+, )                                     (26)

i=0 1

where 1 is the length of wage contracts and (W;WL denotes expectations of the variable ;
for period t+i conditional on information in period t. Currently it is assumed that N equals
4, i.e. wage contracts are set for one year, and negotiated wage contracts are therefore
highly forward looking over the duration of the contract length. Notice, however, since only
a fraction of wage contracts is negotiated each quarter, average wages also exhibit a
substantial amount of inertia, since they are given by

01

W =∑ -WCTNTt-i                                         (27)

= N-I 1

Table 4 lists the crucial parameters of the wage equation. It is assumed that the probability
of filling an open position equals one, i.e. vacancies can be filled within a quarter. Studies
of vacancy durations justify this assumption 3. The last term in wage equation (25),
Srob()9Ct , is approximated by a linear function in unemployment 8 and rewritten as β0-
β1U . Unfortunately there does not exist information on vacancy costs. Therefore we cannot
separately identify the parameters
9C and srob(). We assume symmetric bargain strength
between workers and firms,
β=0.5, for all countries, except for the US, where we assume a
value of 0.25, which conforms more closely with our priors about the US labour market.
The wage equation (25) implies - provided
%EN and 9C are proportional to wage costs - a
long run elasticity of wages with respect to labour productivity equal to one. The wage
equations were estimated over the period 1975-1994 . For the estimation we used data on
replacement ratios obtained from the OECD. We rescale these data such that the average
replacement ratio conforms approximately with the estimates of unemployment benefits as a
percentage of wage costs in Layard et al. (1991).

3 Van Ours and Ridder (1992) report average vacancy duration of 45 days for the Netherlands and
Erdmann (1990) finds similar estimates for Germany. Blanchard and Diamond (1989) report average
durations of less than one month for the US.

16



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