ln(μt) = ζt, where ζt is a white noise process with a zero mean and a finite
variance σ∣ More specifically, we assume that the money supply follows a
random walk, i.e., mt = mt-1 + ξt.
3 General Equilibrium
In this section, we characterize equilibrium of the economy. We first describe
the equilibrium conditions for sector i and then the equilibrium conditions
for the aggregate economy. To compute an equilibrium, we reduced the equi-
librium conditions to four equations, including the household’s first order
condition for setting its contract wage, the pricing equation, the household’s
money demand equation, and an exogenous law of motion for the growth rate
of money supply. We then log-linearize this equilibrium conditions around a
steady state. The steady state which we choose is the zero-inflation steady
state, which is a standard assumption in this literature. The linearized ver-
sion of the equations are listed and discussed below. We follow the nota-
tional convention that lower-case symbols represents log-deviations of vari-
ables from the steady state.
The linearized wage decision equation (16) for sector i is given by
1 P' '
χit = τi-1 s ∑ Ps ∖Pt+s + ^yt+s]
(18)
ʌ-ʃ-- 0 P ` "
The coefficients on output in the wage setting equation in all sectors is given
by
^ = ηll + ηJσ + φ - q))
σ + 6,(1 - σ) + θηu
Where ηcc = uτJc° is the parameter governing risk aversion, ηll = l^c
is the inverse of the labour elasticity, θ is the elasticity of substitution of
consumption goods.
Using equation (9) and aggregating for sector i, we get
Pit = wit +
(⅛σ) *
(20)
where
11