The utility is additively separable and for simplicity, we assume β = 1.
Empirical studies reveal that intertemporal labour supply elasticity, 1∕η l,
is low and is at most 1. In particular, the survey by Pencavel (1986) suggests
that ηbb is between 2.2 and infinity. Therefore, we set ηbb = 4.5, which
implies that intertemporal labour supply elasticity, 1∕η, is 0.2. Following
Ascari (2000), we set θ= 6. Finally, we set ηc= = 1 and σ = 1, which are
all standard values used in the literature (see for example Huang and Liu
(2002)).
Finally, we assume that at time t there is 1% shock to the distrubance
term corresponding to the money growth rate, ξt, so that , ξ(t) = 1, and
ξ(s) = 0 for all s > t.
3.2.1 The Calibration of 7
The key parameter determining aggregate dynamics is 7. The magnitude of 7
is important since it governs how responsive household-unions are to current
and future changes in output (see equation 18). When there is an increase
in aggregate demand, households face higher demand for their labour and
therefore the marginal disutility of labour increases. With higher income
they consume more and marginal utility of consumption falls. The increase
combination of an increase in the marginal disutility of labour and the fall
in the marginal utility of consumption leads household-unions to increase
their wage5. The coefficient 7 determines how wages change in response to
changes in current and future output. If 7 is large, then wages respond a
lot to changes in output which implies faster adjustments and a short-lived
response of output. On the other hand, if 7 is small, then unions are not
sensitive to changes in current and future output. In response to an increase
in aggregate demand, the wage would not change very much and hence wages
are more rigid. In the limit, if 7 = 0, there will be no relationship between
output and wages, so that shocks are permanent. Hence the smaller 7, the
more rigid are wages and a smaller 7 corresponds to a more persistent output.
Estimating 7 as an unconstrained parameter, Taylor found that for the
US 7 is between 0.05 and 0.1. However, in a general equilibrium framework
where we constrain 7 to conform to micro-foundations. CKM find that with
reasonable parameter values, 7 will be bigger than one in a staggered price
setting, whilst with staggered wage setting Ascari finds the value of 7 to be
5In the context of price-setting, the coefficient reflects the slope of hte marginal cost
curve.
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