The Taylor contract is a fundamental concept in New Keynesian economics that explains nominal rigidity through staggered prices and wages. It provides insights into how prices and wages are set for finite periods, leading to implications for macroeconomic policy, particularly in the context of inflation and unemployment.
Historical Context
John B. Taylor introduced the Taylor contract in 1980 to explain the behavior of labor unions in wage-setting. The concept was later extended to price-setting by firms. This model helped to address some limitations of earlier Keynesian models by introducing microeconomic foundations to macroeconomic theory.
Types/Categories
- Wage Taylor Contracts: Initially focused on labor markets where wage contracts are set for specific periods.
- Price Taylor Contracts: Extended to product markets where firms set prices for finite periods.
Key Events
- 1980: John B. Taylor formulates the original model to address wage-setting behavior by labor unions.
- 1990s: The model is generalized to include price-setting by firms.
Detailed Explanations
The Mechanics of Taylor Contracts
In the Taylor contract model, firms set their prices for a predetermined period (e.g., one year). During this period, prices are fixed and cannot adjust to new information or economic shocks. Different firms adjust their prices at different times, leading to staggered price-setting. This staggered adjustment process contributes to overall price rigidity in the economy.
Mathematical Model
Let \( P_t \) denote the general price level at time \( t \). Suppose firms adjust prices every \( m \) periods. The price set by a firm at time \( t \) remains fixed until \( t + m \). The mathematical expression for the Taylor contract can be written as:
where \( \theta \) is the parameter representing the degree of price stickiness.
Charts and Diagrams
graph TD
A[Firm 1 Sets Price]
B[Firm 2 Sets Price]
C[Firm 3 Sets Price]
D[Firm 4 Sets Price]
A -->|Period 1| E[Price Fixed]
B -->|Period 2| F[Price Fixed]
C -->|Period 3| G[Price Fixed]
D -->|Period 4| H[Price Fixed]
E --> I[Adjust]
F --> J[Adjust]
G --> K[Adjust]
H --> L[Adjust]
Importance and Applicability
- Monetary Policy: Understanding nominal rigidity helps central banks design effective monetary policies.
- Inflation Control: Insights from Taylor contracts assist in managing inflation through staggered price adjustments.
- Labor Economics: Offers a framework to analyze wage negotiations and labor market dynamics.
Examples
- Wage Negotiations: Labor unions set wages for two-year contracts, revising them periodically.
- Retail Pricing: Retailers set prices for their products annually, revisiting them every year based on economic conditions.
Considerations
- Degree of Rigidity: The extent of price or wage stickiness can vary based on industry and market conditions.
- Economic Shocks: The inability to adjust prices immediately may lead to short-term inefficiencies.
Related Terms with Definitions
- Calvo Contract: Another model of nominal rigidity where the probability of price adjustment is constant.
- Price Stickiness: The resistance of prices to change despite changes in supply and demand.
- Wage Rigidity: The phenomenon where wages do not adjust immediately to changes in labor market conditions.
Comparisons
- Taylor vs. Calvo Contracts: Taylor contracts assume fixed periods for price adjustments, while Calvo contracts assume a constant probability of adjustment each period.
Interesting Facts
- John Taylor also formulated the Taylor Rule, a guideline for central banks in setting interest rates.
- The Taylor contract model has been widely used in policy simulations and macroeconomic forecasting.
Inspirational Stories
John Taylor’s work has been instrumental in bridging microeconomic foundations with macroeconomic outcomes, influencing generations of economists and policymakers.
Famous Quotes
“Inflation is the one form of taxation that can be imposed without legislation.” – Milton Friedman
Proverbs and Clichés
- “A stitch in time saves nine.”
- “Slow and steady wins the race.”
Expressions, Jargon, and Slang
- Sticky Prices: Prices that do not change easily.
- Staggered Adjustments: Adjustments that occur at different times across different firms or sectors.
FAQs
What is the primary significance of the Taylor contract?
How does the Taylor contract model compare to the Calvo contract model?
Can the Taylor contract model be applied in modern economic analysis?
References
- Taylor, J.B. (1980). “Aggregate Dynamics and Staggered Contracts.” Journal of Political Economy, 88(1), 1-23.
- Woodford, M. (2003). “Interest and Prices: Foundations of a Theory of Monetary Policy.” Princeton University Press.
Summary
The Taylor contract is a pivotal concept in New Keynesian economics that provides a structured way to understand nominal rigidity through staggered price and wage adjustments. Initially focused on wage-setting by labor unions, it has been expanded to encompass price-setting by firms, offering valuable insights for policymakers and economists in managing inflation and designing effective monetary policies. The model’s contributions to understanding macroeconomic stability continue to be significant, making it a cornerstone in economic theory.
