the basic building blocks of the model. However, the novel aspects of this
paper only begin with the wage setting process. Firstly, we describe the
behavior of firms which is standard. Then we describe the structure of the
contracts in a GTE, the wage-setting decision and monetary policy.
2.1 Firms
There is a continuum of firms f ∈ [0,1], each producing a single differentiated
good Y(f ), which are combined to produce a final consumption good Y. The
production function here is CES with constant returns and corresponding
unit cost function P
l f1 --- 1 -=-
Yt = Y Yt(f)-^-df (1)
√0
" rl "I -ɪ-
Pt = J0 Pdf (2)
The demand for the output of firm f is
γ,t=( PPt ) γt (3)
Each firm f sets the price Pft and takes the firm-specific wage rate Wft as
given. Labor Lft is the only input so that the inverse production function is
1
Lf. = ( γf )τ (4)
Where σ ≤ 1 represents the degree of diminishing returns, with σ = 1 being
constant returns. The firm chooses {PftYft, Lft} to maximize profits subject
to (3,4), yields the following solutions for price, output and employment at
the firm level given {Yt, Wft,Pt}
Pf = (V ) ⅛ 'Λ
(5)
(6)
(7)
>»- "(Wf) V
-- ..(Wf)'-