Central bank independence, centralization of wage bargaining, inflation and unemployment: Theory and some evidence

This paper proposes a conceptual framework to investigate the effects of central bank independence, of the degree of centralization of wage bargaining and of the interaction between those institutional variables, on real wages, unemployment and inflation, in a framework in which unions are averse to inflation. This aversion moderates unions' wage demands as they attempt to induce the central bank to inflate at a lower rate. An increase in the degree of centralization of wage bargaining (a decrease in the number of unions) triggers two opposite effects on real wages, unemployment and inflation. It reduces the substitutability between the labor of different unions and therefore the degree of effective competition between them. This 'reduced competition effect' raises real wages, unemployment and inflation. But the decrease in the number of unions also strengthens the moderating effect of inflationary fears on the real wage demands of each union. This 'strategic effect' lowers real wages, unemployment and inflation. For sufficiently inflation averse unions the interaction between those two effects produces a Calmfors-Driffill type relation between real wages and centralization. The paper analyzes the effects of central bank independence on the position and the shape of this relation, as well as on inflation and unemployment. The paper features two mechanisms, one of which is novel, through which monetary institutions have real effects. The model implies that if there is a single union social welfare is maximized when the central bank attaches a zero weight to inflation. But when the number of unions is larger than one this result is no longer true in general. Empirical evaluation of some of the theoretical implications, using data from 19 developed economies, is for the most part supportive of those implications.