The prevalence of labor contracts with fixed duration seems surprising. Why is a fixed duration preferred to a stochastic duration that depends on the consumer price index? In this paper, the specification of the contract duration is determined endogeneously. The wage rate can be indexed to the consumer price index, but there is a loss since the indexation must be the same for different types of shocks. This loss increases with the variability of the contract duration. Since the loss due to the contracting cost depends on the expected discounted duration only, a fixed duration is chosen.

[This paper studies the welfare consequences of inflation and disinflation in a model in which firms incur a fixed cost of price adjustment. It is shown that a moderately increasing price level is associated with higher social welfare than a perfectly stable price level, and the model therefore provides theoretical support for the widespread belief that a little bit of inflation is good for the economy. Nevertheless, it is also true that the eradication of a moderate inflation leads to an increase in social welfare.]

This article incorporates contract reopeners into the analysis of contract duration and compares contracts with a reopener to contracts that cannot be reopened. The model contains relative and nominal shocks. It is shown that the stated duration of a reopenable contract is shortened by uncertainty associated with small shocks but lengthened by uncertainty associated with large shocks. However, the discounted expected duration decreases with the uncertainty associated with both small and large shocks. There exists a critical size of a large shock for which a reopenable contract and a contract with an immutable duration are equally attractive.

Journal Article Real Shocks, Efficient Risk Sharing, and the Duration of Labor Contracts Get access Leaf Danziger Leaf Danziger Bar-Ilan University, Israel Search for other works by this author on: Oxford Academic Google Scholar The Quarterly Journal of Economics, Volume 103, Issue 2, May 1988, Pages 435–440, https://doi.org/10.2307/1885125 Published: 01 May 1988

There exists by now a burgeoning literature concerned with the consequences of a fixed cost of price adjustment. Due to this cost, a monopolistic firm does not necessarily adjust its price even though the current price deviates from the price that would maximize the firm's current profit. As a result, the production generally differs from what it would be in the absence of a menu cost, with the effect of inflation on the average output and welfare under monopolistic competition being ambiguous and depending in a complicated way on the profit and demand functions. 1 However, one strong result holds unambiguously for all profit and demand functions: at low inflation rates, the average output and welfare are above their levels at full price stability where firms charge the static monopoly price.2 The driving force is that discounting makes a firm more concerned with its real profits earlier in a period with a constant nominal price than with its real profits later in the period. In fact, as the inflation rate approaches zero, the firm's initial real price converges to the profit-maximizing real price, while the terminal real price converges to a smaller real price. At low inflation rates, therefore, a firm's price is most of the time below the price that would maximize the current profit. Since output and welfare under monopolistic competition are inversely related to price, average output and welfare are higher than under full price stability. The inevitable conclusion is that the economy benefits from a little bit of inflation. A critical assumption underlying this result is that firms can continuously adjust their production to satisfy demand. So while the menu-cost literature explicitly assumes that there is a small fixed cost incurred at each price adjustment, it also implicitly assumes that it is costless to continuously adjust the quantity of output.3 This is, however, a questionable assumption. There is some empirical evidence indicating the existence of a cost of quantity adjustment, part of which is fixed in that it does not depend on the size of the adjustment.4 The cost of quantity adjustment stems from the need to rearrange and reorganize the factor inputs for the new level of production and includes managerial time and effort. A fixed cost of quantity adjustment rules out any continuous adjustment of the production to satisfy the increasing demand that results from a decreasing real price within a period with a constant nominal price. Under the reasonable assumption that the menu cost does not exceed the fixed cost of quantity adjustment,5 in an inflationary environment a firm chooses to adjust its nomi-

This paper studies a general-equilibrium model of a dynamic economy with menu costs. Each firm's productivity is exposed to idiosyncratic and aggregate productivity shocks around a trend, and the money supply to monetary shocks around a trend. All consumption, pricing, and production decisions are based on optimizing behavior. There exists a staggered Markov perfect equilibrium with prices determined by a two-sided (s, S) markup strategy. The paper analyzes the optimal markup strategy and investigates the dynamics of the price index and the aggregate output. The welfare consequences of the uncertain aggregate productivity and money supply are also examined.

The prevalence of labor contracts with fixed duration seems surprising. Why is a fixed duration preferred to a stochastic duration that depends on the consumer price index? In this paper, the specification of the contract duration is determined endogenously. The wage rate can be indexed to the consumer price index, but there is a loss since the indexation must be the same for different types of shocks. This loss increases with the variability of the contract duration. Since the loss due to the contracting cost depends on the expected discounted duration only, a fixed duration is chosen.

This paper studies the welfare consequences of inflation and disinflation in a model in which monopol istic firms incur a fixed cost of price adjustment. It is shown that a moderately increasing price level is associated with higher social welfare than a perfectly stable price level, and the model therefore provides theoretical support for the widespread belief that a little bit of inflation is good for the economy. Nevertheless, it is also tr ue that the eradication of a moderate inflation leads to an increase in social welfare.

In an interesting paper, Julio Rotemberg (1983) extends the works of Eitan Sheshinski and Yoram Weiss (1977) and Michael Mussa (1981) to examine the aggregate consequences of monetary growth in an economy in which sellers incur a fixed cost of price adjustment. The fixed cost prevents a continual adjustment of individual prices, so each seller keeps his price constant in periods of discrete length, increasing his price in discrete jumps at the end of these periods. A central feature of the inflationary process is therefore that relative prices become dispersed around their means, and the theory predicts that even a fully anticipated inflation increases the variability of relative prices.' The empirical evidence on this point does, however, appear to be mixed. On the one hand, Richard Parks (1978) and Stanley Fischer (1981a,b; 1982) conclude that anticipated inflation does increase relative-price variability (which Fischer interprets as providing empirical support for the theory); on the other hand, Mario Blejer (1981, 1983) and Blejer and Leonardo Leiderman (1982) find that anticipated inflation has no effect, or only a very weak effect on relative-price variability (which makes John Taylor, 1981, doubt the quantitative significance of the theory).2 This paper uses Rotemberg's theoretical framework to demonstrate that the proxy for relative-price variability adopted in the empirical literature does not properly capture the relative-price variability that is caused by a fixed cost of price adjustment. The methodology of the above cited studies is therefore not appropriate for evaluating the empirical relevance of the fixed-cost theory, and the divergence of their results is not surprising. Specifically, the proxy which consists of the variance of the rates of price change between successive observations does not always increase with the anticipated inflation. Even with disaggregate data,3 the proxy decreases with the anticipated inflation in approximately half of any interval of inflation rates for which a seller adjusts his price no more than a given number of times between successive observations. Moreover, the relationship between the anticipated inflation and the proxy depends on such extraneous factors as the timing of the observations. A change in the timing may change a positive relationship between the anticipated inflation and the proxy to a negative one, and vice versa. The paper also proposes alternative, more satisfactory measures of relative-price variability and provides empirical support for the theoretical conclusions.