A business cycle model with nominal wage contracts and government

We incorporate nominal wage contracts and government into a quantitative general equilibrium framework. Thus, our model includes three types of shocks: a fiscal shock, a monetary shock, and a technology shock. We show that it is possible in this type of environment to generate a low correlation between hours worked and the return to working, a moderately negative correlation between output and aggregate prices and a moderately positive correlation between the real wage rate and output. In sharp contrast with RBC models with indivisible labor, wage contracts magnify mainly the effect of monetary shocks on the volatility of hours worked. An attractive feature of the contracting model is that it avoids a trade-off that RBC models have to face in their predictive capacity when additional features are incorporated to them.