Taylor contract (economics)

The Taylor contract or staggered contract was first formulated by John B. Taylor in his two articles, in 1979 "Staggered wage setting in a macro model".^[1] and in 1980 "Aggregate Dynamics and Staggered Contracts".^[2] In its simplest form, one can think of two equal sized unions who set wages in an industry. Each period, one of the unions sets the nominal wage for two periods (i.e. it is constant over the two periods). This means that in any one period, only one of the unions (representing half of the labor in the industry) can reset its wage and react to events that have just happened. When the union sets its wage, it sets it for a known and fixed period of time (two periods). Whilst it will know what is happening in the first period when it sets the new wage, it will have to form expectations about the factors in the second period that determine the optimal wage to set. Although the model was first used to model wage setting, in new Keynesian models that followed it was also used to model price-setting by firms.

The importance of the Taylor contract is that it introduces nominal rigidity into the economy. In macroeconomics if all wages and prices are perfectly flexible, then money is neutral and the classical dichotomy holds. In previous Keynesian models, such as the IS–LM model it had simply been assumed that wages and/or prices were fixed in the short-run so that money could affect GDP and employment. John Taylor saw that by introducing staggered or overlapping contracts, he could allow some wages to respond to current shocks immediately, but the fact that some were set one period ago was enough to introduce a dynamics into wages (and prices). Even if there was a one off shock to the money supply, with Taylor contracts it will set off a process of wage adjustment that will take time to react during which output (GDP) and employment can differ from the long-run equilibrium.