The Effect of Heterogeneous Wage Contracts on Macroeconomic Volatility in a Financially Fragile Economy

Kim, Jongheuk Article The Effect of Heterogeneous Wage Contracts on Macroeconomic Volatility in a Financially Fragile Economy East Asian Economic Review (EAER) Provided in Cooperation with: Korea Institute for International Economic Policy (KIEP), Sejong-si Suggested Citation: Kim, Jongheuk (2017) : The Effect of Heterogeneous Wage Contracts on Macroeconomic Volatility in a Financially Fragile Economy, East Asian Economic Review (EAER), ISSN 2508-1667, Korea Institute for International Economic Policy (KIEP), Sejong-si, Vol. 21, Iss. 2, pp. 167-197, https://doi.org/10.11644/KIEP.EAER.2017.21.2.328 This Version is available at: https://hdl.handle.net/10419/316524 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ PISSN 2508-1640 EISSN 2508-1667 an open access journal East Asian Economic Review vol. 21, no.2 (June 2017) 167-197 http://dx.doi.org/10.11644/KIEP.EAER.2017.21.2.328 ⓒ Korea Institute for International Economic Policy The Effect of Heterogeneous Wage Contracts on Macroeconomic Volatility in a Financially Fragile Economy Jongheuk Kim National Assembly Budget Office [email protected] I build a small open economy (SOE) dynamic stochastic general equilibrium (DSGE) model to investigate the effect of a heterogeneous wage contract between regular and temporary workers on a macroeconomic volatility in a financially fragile economy. The imperfect financial market condition is captured by a quadratic financial adjustment cost for borrowing foreign assets, and the labor market friction is captured by a Nash bargaining process which is only available to the regular workers when they negotiate their wages with the firms while the temporary workers are given their wage which simply equals the marginal cost. As a result of impulse responses to a domestic productivity shock, the higher elasticity of substitution between two types of workers and the lower weight on the regular workers in the firm’s production process induce the higher volatilities in most variables. This is reasoned that the higher substitutability creates more volatile wage determination process while the lower share of the regular workers weakens their Nash bargaining power in the contract process. Keywords: DSGE, Nash Bargaining Wage Contract, Labor Market Friction, Open Economy Macroeconomics, Financial Market Fragility JEL classification: C68, E52, F41, G10 I. INTRODUCTION During the last decade, while the imperfect financial integration condition for some developing countries has been relaxed, a relatively high level of economic volatility affected by foreign interest rates has been consistently suspected. Figure 1 shows an example of Korean government bonds market, which connectedness to the markets of primary counterpart countries has been grown recently but the volatility of spreads between Korea and the others have been fluctuated at relatively high level compared to those of the countries within Eurozone, which volatilities converged to a very low level, as shown in ECB (2006). As a financial ID 168 Jongheuk Kim ⓒ Korea Institute for International Economic Policy openness does not fully explain the effect of foreign interest rates on domestic fluctuations, an investigation on the other possible factors that affect the volatility in a country with this type of financial fragility should be studied. Figure 1. Price-Based Indicators for Financial Integration of Korean Government Bonds Market Source: Fred (all rates are 3-year government bonds rates) In this paper, I build a dynamic stochastic general equilibrium (DSGE) model to investigate this issue. To do so, based on benchmark open economy New Keynesian assumptions such as monopolistic competition, price rigidity, and financial and commodity markets openness, which are based on the seminal benchmark models such as Gali and Monacelli (2005) or Gali (2008), a quadratic financial adjustment cost is additionally assumed as a default friction to capture the financial fragility. A linear quadratic form of the financial adjustment cost is widely used in the related literature because not only it easily guarantees a steady state condition but also a model with it generally fits the data well, especially recent trends in some developing economies with specific economic conditions. Here I adopt the form of Demirel (2009) and Demirel (2010) in which the form creates interest rate differentials between home and foreign countries. To capture the main volatility driver in the model, a polarized labor market condition is assumed. During the last decade, the labor market inequality between full-time and part-time workers in Korea in terms of duration of work and wage level has been widened. The left-side of Figure 2 shows that wage fluctuations of part-time workers have been more volatile than full-time workers’, and the gap between possibilities of working for longer term for the two types of workers has The Effect of Heterogeneous Wage Contracts on Macroeconomic Volatility in a Financially Fragile Economy 169 ⓒ 2017 East Asian Economic Review never been narrowed. Moreover, the right side of Figure 2 represents that the portion of part-time workers has been increased in the younger group while the portion in the overall ages has been decreased. These simple statistics implies that as growing portion of young part-time workers suffers uncertainty on their job security, wage level, or expectation of future incomes, and experiences less wage bargaining power. This phenomenon can also possibly affect the macroeconomic fluctuations by increasing overall uncertainty for longer terms and thus distracting the present level of consumptions of some households. In order to investigate the effect of this type of labor friction on economic volatility, I adopt a heterogeneous wage contracts assumption developed by Mattesini and Rossi (2009) and Matsui and Yoshimi (2015). In these papers, one type of workers is given totally flexible wage where the marginal utility of labor equals marginal disutility of it, while the other group of workers has a Nash-bargaining power which makes different wage dynamics between those two groups. Figure 2. Korean Labor Market Conditions: Full-time vs. Part-time Source: KOSTAT(kostat.go.kr) The main results of this paper are twofold. First, the higher elasticity of substitution between two types of workers induces the higher volatilities in most macroeconomic variables in the impulse responses to the domestic productivity shock. This is because the substitutability plays an important role in wage dynamics in the model, especially by increasing a labor elasticity of Nash bargaining power for the regular workers and thus making a wage determination process of both workers more volatile. Second, the lower weight on the regular workers in the firm’s production process also increases the macroeconomic fluctuations. This is 170 Jongheuk Kim ⓒ Korea Institute for International Economic Policy because the lower share of regular workers has the same effect with the lower Nash bargaining power for that type of workers, hence the contract position of the workers is weaken, which ultimately induces the more unstable economic condition. The main contribution of this paper is that it introduces a friction to the labor market in the DSGE model by inviting an inequality between regular and temporary workers to explain the recent trend in the business cycles of specific type of economy. Many economists view developing economies as financially fragile. However, these regions also have a high level of misallocation of labor demand or, at least, have a relatively weak wage bargaining power of high portion of workers, namely a temporary worker. As low level of macroeconomic growth has been globally sustained for a decade after 2008 financial crisis, quality of labor market in some developing economies has been worsened. This paper captures a part of this trend by introducing part-time workers’ different wage bargaining power which affects dynamic equilibrium conditions and overall economic sensitivities to exogenous shocks. By doing this, despite some technical limitations, the paper explains that this type of labor market friction can partially explain the sustained volatility in a financially fragile economy. The remainder of the paper is organized as follows. The second section explains the theoretical DSGE model in detail. This section also qualitatively analyzes the effect of the assumed frictions on the business cycle of the economy. The third section explains the parameter values used in the quantitative analysis and notes the impulse responses of the system of equilibrium equations to various types of exogenous shocks. Finally, the fourth section concludes the paper. II. MODEL The theoretical analysis of the combined effect of labor market friction and financial market fragility on the business cycles and monetary policy decisions begins by building a small open economy DSGE model. Here, I follow Gali and Monacelli (2005) and Gali (2008) as benchmark frameworks for the New Keynesian open economy model. Based on these baseline models, I adopt a quadratic financial adjustment cost to create imperfect financial market accessibility for a domestic country. In addition I use interest rate differentials between the home and world economies to replicate the foreign bond holdings in the small open economy, following the works of Schmitt-Grohe and Uribe (2003) and Demirel (2010). In The Effect of Heterogeneous Wage Contracts on Macroeconomic Volatility in a Financially Fragile Economy 171 ⓒ 2017 East Asian Economic Review this setting, while a foreign country has no additional cost to access the foreign currency denominated bonds, the home country pays an additional cost to hold a certain amount of foreign assets. Additionally, I add two more assumptions for an asymmetric small open economy case. First, home and foreign countries have different size economies. The economic impact of the home country is assumed to be negligible compared to that of the world economy. Therefore, the home country is given the foreign output, consumption, and prices. This assumption makes it possible to observe the response of a domestic business cycle to exogenous foreign demand and monetary shocks. Second, domestic households can access both home and foreign currency denominated asset markets, but foreign agents can only access the foreign asset market. This is because the size of the domestic financial market is too small to be significant to the dynamics of the international financial markets. Along with these unique assumptions, I include monopolistic competition and a sticky prices framework, following Calvo (1983) and Yun (1996) to create money non-neutrality and to allow a monetary policy to stabilize economic volatility. Furthermore, the law of one price and purchasing power parity hold. Lastly, this model assumes a cashless economy, following Woodford (2003) because holding cash in a utility function does not offer any improvement to the real side of the economy and, thus, becomes a useless assumption. 1. Households Let us consider two connected economies, Home (H) and Foreign (F) countries, which are separately populated with a continuum of agents, and the total population is normalized to one. Home and foreign consumers share the same form of utility function and maximize this utility function given a country-specific budget constraint. The utility function of a representative home agent is given by 1 1,, 00 () ( , ) 11 + −  =  + −   −+  G t M t tt tt t LL C U C L E    (1) 172 Jongheuk Kim ⓒ Korea Institute for International Economic Policy where t C refers to the aggregate consumption level at time ,t  is a time discounting factor, 0  is the intertemporal elasticity of substitution in private consumption, and 0  is the inverse of the elasticity of labor supply. 1 In their case, 1/  can be interpreted as a Frisch labor supply elasticity, which explains the substitution effect with respect to the change of wage rate. ,Gt L is the number of hours worked by full-time, or regular workers, and ,Mt L is the number of hours worked by part-time, or temporary workers. Furthermore, the regular and temporary workers are aggregated such as 1 ,, 0 1 ,, 0 () () G t G t M t M t L L j dj L L j dj = =   (2) where [0,1]j denotes the variety of goods. The domestic aggregate consumption level, t C consists of two parts, namely consumption for home and foreign final goods, and is defined by 1 1 1 1 1 (1 ) ( ) ( ) ,, C C C t H t F t         −−  −   − +     (3) where [0,1]   captures the degree of openness to foreign consumption by domestic households, which inversely denotes a home bias preference, and 1   is an index of intratemporal elasticity of substitution between home and foreign final goods. Here, ,Ht C is an index of domestic goods, using the constant elasticity of substitution functional form 1 This elasticity is discussed in detail in Christiano et al. (2010) The Effect of Heterogeneous Wage Contracts on Macroeconomic Volatility in a Financially Fragile Economy 173 ⓒ 2017 East Asian Economic Review 11 1 ,, 0() H t H t C C j dj    −−     where 1   represents the elasticity of substitution among varieties. Then, ,Ft C is an index of foreign produced (imported) goods, defined by 11 1 ,, 0() F t F t C C j dj    −−     Note that  is common across the consumption of home and foreign goods. This is quite a strong assumption, but since it does not weaken any part of the main argument of this study, I accept it for the sake of simplicity. An aggregate consumption index for a foreign representative household can be similarly defined using an asterisk: 1 1 1 1 1 * * * * * ,, ( ) ( ) (1 ) ( ) t H t F t C C C         −− −   + −    (4) where *[0,1]   represents the degree of openness to goods produced in the home country, satisfying *, =  meaning both home and foreign countries have the same degree of openness to each other. Then, *,Ht C and *,Ft C are defined as the amount of consumption by foreign households for goods produced in the home and foreign countries, respectively. Next, price indexes for the commodity markets in the home and foreign countries, based on the above preferences and aggregate consumption indexes, are given by 1 11 1 ,, (1 ) t H t F t P P P    −− −   − +  (5) and 174 Jongheuk Kim ⓒ Korea Institute for International Economic Policy 1 * * 1 * 1 1 ,, (1 ) t H t F t P P P    −− −   + −  (6) respectively. Here, t P and * t P are the home and foreign consumer price indexes (CPI) and ,Ht P and ,Ft P are sub-indexes for the home and foreign produced goods consumed in the home country, respectively. Then, *,Ht P and *,Ft P are interpreted as the price indexes of home and foreign produced goods, respectively, expressed in the foreign currency. Each of the four sub-price indexes are expressed by an aggregation, as follows: ()() ()() 11 11 11 11 , , , , 00 11 11 11 * * 1 * * 1 , , , , 00 ( ) , ( ) , ( ) , ( ) H t H t F t F t H t H t F t F t P P j dj P P j dj P P j dj P P j dj     −− −− −− −− == ==   (7) Using the above aggregations, we can solve for the optimal allocation of demand for varieties of goods in the home country: ,, , , , , ,, ( ) ( ) ( ) ; ( ) H t F t H t H t F t F t H t F t P j P j C j C C j C PP  −−     ==             (8) Next, the aggregate total expenditure for the home and foreign goods follow directly from (8): 11 , , , , , , , , 00 ( ) ( ) ; ( ) ( ) H t H t H t H t F t F t F t F t P j C j dj P C P j C j dj P C==  (9) Now, the optimal allocations of expenditure for home and foreign goods are given by: ,, ,, (1 ) ; H t F t H t t F t t tt PP C C C C PP   −−     = − =         (10) The Effect of Heterogeneous Wage Contracts on Macroeconomic Volatility in a Financially Fragile Economy 181 ⓒ 2017 East Asian Economic Review where () t Yj is the output level of firm j , t A is the exogenous total factor productivity following an AR(1) stochastic process. () t Lj is an aggregation of the two types of workers following CES fashion,     1 ,, ( ) ( ) (1 ) ( ) t G t M t L j L j L j     = + −   (28) where  represents the weight on the regular workers in the firm’s production, and 1 1  − means the elasticity of substitution between the regular and temporary workers. The demand function for two types of labor inputs are derived by 1 1 , , 1 1 , , 1 ( ) ( ) () 1 ( ) ( ) 1 ( ) Gt G t t t Mt M t t t W L j L j Wj W L j L j Wj     − −  =   = −  (29) where the wage index of the overall group of workers is defined by     1 11 11 11 ,, ( ) ( ) (1 ) ( ) t G t M t W j W j W j       − −− −−  = + −   (30) The marginal cost of each firm j is ( ) ( ) tt MC j W j= (31) Following Mattesini and Rossi (2009) and Matusi and Yoshimi (2015), I assume there are different wage bargaining powers between two types of labor force groups. The temporary workers are given their real wages where the marginal utility of labor input and the marginal cost of the input equal, 182 Jongheuk Kim ⓒ Korea Institute for International Economic Policy ,,, () Mt G t M t t t WLL PC  =+ (32) Denotation j can be dropped because each firm pays an identical level of wages to the temporary workers. Contrary to the temporary workers, the regular workers have a negotiating power on their wages with the firms. The wage contract of firm j is processed following a simple Nash bargaining objective function, 1 ( ) [ ( )] [ ( )] tt j j j   −  =  (33) where the objective function of the regular workers is defined by, , , , ( ) ( ( ) ) ( ) G t M t G t j W j W L j  = −  (34) and  denotes the degree of bargaining power of the regular workers. Equation (33) and (34) mean that the regular workers use their bargaining power to obtain net gains from firm j ’s profit, which is derived by ( ) [ ( ) ( )] ( ) t t t t j P j MC j Y j = −  (35) The first order condition of the regular workers’ maximizing problem is derived by 1 ,, ( ) ( ) ( ) ( ) (1 ) 0 ( ) ( ) ( ) ( ) t t t t t G t t G t j j j j j W j j W j      −       + − =             (36) Using (34), the relation between two different wages are derived by ,, , () ( ) ( ) (1 ) ( ) G t M t l G t t t W j W W j V j V j    −=+− (37) where The Effect of Heterogeneous Wage Contracts on Macroeconomic Volatility in a Financially Fragile Economy 183 ⓒ 2017 East Asian Economic Review ,, ,, ,, ( ) / ( ) () ( ) / ( ) ( ) / ( ) () ( ) / ( ) G t G t l t G t G t tt t G t G t L j L j Vj W j W j jj Vj W j W j   =   = (38) The first equation of (38) is the labor elasticity of the Nash bargaining wage and the second one is the production elasticity of the Nash bargaining wage. Following Matsui and Yoshimi (2015) it is natural to assume that both elasticities are positive values. Next, following Calvo (1983) and Yun (1996) , the model assumes a staggered price setting. A randomly selected portion of producers, (1 )  − , set a new price level at each period, while the remaining firms,  , keep their price level as it was in the previous period. Therefore,  captures the degree of price rigidity. Let ,() Ht Pj be the optimal price set by firm j at time t . With the staggered price setting described above, ,, ( ) ( ) H t k H t P j P j += . Then, the problem faced by a typical firm, j , is given by ( ) ,, , , 0 {} Ht k t t t t k t t k H t t k Pk Max E E Y P   + + + =  −   (39) subject to the international demand constraints, ( ) ,* , , , , , () ) ( Ht d t t k H t k H t k t k H t H t k P Y j C C Y P P  − + + + + +   +     (40) where ,kt k t t t k t t l CP CP   − + + +              and tk  + denotes the nominal marginal cost at period tk+ with respect to the staggered price setting, ,Ht P , and is determined by the previously derived real wage equation. Note that firm specific index j can 184 Jongheuk Kim ⓒ Korea Institute for International Economic Policy be dropped in this problem as well, because all firms use the same price setting, subject to the same marginal cost and the same resource constraint. Furthermore, note that this problem is identical to the price setting of Gali and Monacelli (2005), with the exception of the nominal marginal cost structure. The first-order condition yields , , , 0 0 1 kt t t k t t k H t t k k E Y P     + + + =    − =   −    (41) Note that in the perfect flexible price setting, 0  = , the above equation reproduces ,1 H t t P   =− . This can be rearranged using stationary variables, as follows: , , , , 0, 1 , 1 ( ) 0 1 H t H t H t k kt t k t t k t k kt k H t H t P P P E C Y MC P P P    + − + + + =+ − −   −=    −     (42) where tk MC + is the real marginal cost at time tk+ , as shown above, and is equal to , tk H t k P  + + . One can now define the new price index of domestically produced goods under the staggered price setting, 1 11 1,, 11 1 , , 1 , , 1 , 1 (1 )( ) (1 ) H t H t H t H t H t H t H t PP P P P PP        −− −− − − −−     = + −  = + −      (43) 4. Monetary Authority A fiscal authority organizes a lump-sum tax or transfer. A monetary authority sets the level of the nominal interest rate, following a form of the traditional Taylor rule. The nominal interest rate rule is given by The Effect of Heterogeneous Wage Contracts on Macroeconomic Volatility in a Financially Fragile Economy 185 ⓒ 2017 East Asian Economic Review ( ) , 1 , ( )( ) ( )( ) y y Ht t tt t t H t t PY R R Z PY YRZ Y      −   =     =   (44) where   and y  are policy parameters, weighted by domestic inflation and output changes, respectively. Then, y  and R are the output and nominal interest rate steady-state values, respectively, and t Z is an exogenous monetary policy shock, which follows an AR(1) stochastic process. 5. Aggregations, Market Clearing Conditions, and Competitive Equilibrium The aggregate level of output in the home country is 11 1 0() tt Y Y j dj    −−  =   (45) And the equilibrium condition for each good and labor match-up induces t t t Y AL= (46) The market clearing condition for each differentiated home final good, j , is given by * ,, ( ) ( ) ( ) t H t H t Y j C j C j=+ (47) The world market clearing condition is given by ** tt YC= (48) 186 Jongheuk Kim ⓒ Korea Institute for International Economic Policy The world output follows an AR(1) stochastic process which information is provided in detail in the next section. Therefore, it is exogenously given to the home country agents since the demand for world output from the home economy is assumed to be negligible. The home currency denominated bond market is cleared such that , 0 Ht B= (49) And the world bond market is automatically cleared by Walras’ law. The homeproduced goods market clearing condition (47) can be rewritten as * ,, * ,, * ,, ** , , , , * ** ,, , , , , ( ) ( ) () ( ) ( ) (1 ) ( ) () (1 ) H t H t t H t H t H t H t H t H t H t H t tt H t t H t t H t H t H t t H t t P j P j Y j C C PP P j P P j P CC P P P P P j P P C PP        −− −− − − −−     =+                   = − +                    = − +      ** *t t C P  −         (50) Substituting (50) into (45) gives ( ) * , , , , ** * ,* (1 ) (1 ) (1 ) H t H t H t H t t t t t t t t t t t Ht t t t t P P P P Y C C C C P P P PQ PCC P            − − − − −        = − + = − +                 = − +     (51) The law of one price and the definition of the real exchange rate are used in the second step of the above calculation. The above national account states that the overall supply of the domestic output should be equal to the demand from both home and foreign consumers, which depend on the commodity market openness and the price levels of the home country. Furthermore, for the convenience of later The Effect of Heterogeneous Wage Contracts on Macroeconomic Volatility in a Financially Fragile Economy 187 ⓒ 2017 East Asian Economic Review discussion, (51) can be rewritten in terms of price levels, private consumption, exogenous foreign demand, and terms of trade: ( ) ( ) (1 ) * (1 ) t t t t t Y S C C     −−  = − +  (52) Note that as  converges to zero, which means the home economy becomes an autarky condition, (51) and (52) converge to the benchmark commodity market clearing condition, tt YC= . Since all workers are assumed to move across firms freely, the Nash bargaining wages are identical across firms, ,, () G t G t W j W= (53) Therefore, overall wages and marginal cost can be also identical: () () () () ll tt tt tt tt V j V V j V W j W MC j MC  = = = = (54) Combined with (28) and (29), labor demand functions for each group of workers are derived by 1 11 , ,0 1 11 , ,0 () 1 () 1 1 Gt t G t t tt Mt t M t t tt WPj L Y dj WP WPj L Y dj WP       − −     =             =     −       (55) Four exogenous variables are defined here: 188 Jongheuk Kim ⓒ Korea Institute for International Economic Policy 2 1 2 1 * * 2 1 * * 2 1 log log log log log log log log t A t A t Z t Z t Y t Y t A t R AA ZZ YY RR     − − − − =+ =+ =+ =+ (56) A competitive equilibrium is defined by a stream of endogenous variables, , , , , , , 0 { , , , , , , , , , , , , , , , , , } l t t t G t M t F t t t G t M t t t t H t t t t t t C Y L L L B B W W W R MC S V V P  =  with five exogenous variables, * * * 0 { , , , , } t t t t t t A Z Y R C  = , which solves (14), (23), (25), (26), (28), (30), (32), (37), (38), (43), (44), (46), (48), (52), (54), (55), (56), and the relation between inflation and price level, 1 t t t P P− = . 6. Linearized System of Equations To make the problem feasible, the first order conditions for the optimal allocation equilibrium described in the previous subsection are log-linearized. For any arbitrary variable t X , the log-linearized variable is denoted by t x , such as t t XX xX − .     ** 1 1 1 , 0( 1) t t t t t t t t t F B F t E s s E c c E c c B b    + + +  = − − − − + − −   (57) ,1 () t H t t t t E s s    + = + − (58)     ** 1 1 1 , 0( 1) t t t t t t t t t F B F t E s s E c c E c c B b    + + +  = − − − − + − −   (59)     * 1 1 , 0 (1 ) t t t t t t t F B F t E s s E r r B b  ++ = − − − + − +  (60) The Effect of Heterogeneous Wage Contracts on Macroeconomic Volatility in a Financially Fragile Economy 189 ⓒ 2017 East Asian Economic Review ,, 1 t G t G M t M l l l    =  +  (61) 11 11 11 ,, (1 ) GM t G t M t WW w w w WW     −− −−   = + −     (62) , , , GM M t t G t M t t G M G M LL w p l l c L L L L        − = + +     ++     (63) ,, 2 ( ) (1 ) ( (1 ) ) ll GG t M t t t l M Ww w V v V v W V V     − = + −  +− (64) 11 1, 2 1(1 ) ( ) (1 ) lG t G t t W v w w VW      − − =   −   −  − (65) , () 1 l t G t t t v w w v   =  − + − (66) _ , , 1 H t t H t t E mc     +  =+  (67) , __ H t y t tt y zr     = + + (68) t t t y a l=+ (69) ** tt yc= (70) 1t t t pp  − =− (71) tt mc w= (72) 190 Jongheuk Kim ⓒ Korea Institute for International Economic Policy ** * * * * (1 ) c c c t t t t c c c c c c y c s c            − = + − +   + + +  (73) ( ) ,, 1 1 G t G t t t l w w y  = − + − (74) ( ) ,, 1 1 = − + − M t M t t t l w w y  (75) where (1 ) cC  − , *(1 ) * cSC    −  , () ( ) (1 ) w N W P WL P  = +  − , 2 (1 ) ( ) (1 ) N n N L WL P  − = +  − , ( ) 2 (1 ) , −  = + −   G G M G L L L        ( ) 2 (1 ) (1 ) , −  = + −  −  M G M M L L L         (1 )(1 )    −− = , _ tt mc mc mc=− , 1 mc   = −  − − , and _ t r and _ t y are defined similarly. The above system of equations can be solved by using the eigenvalue-eigenvector decomposition technique developed by Sims (1999). III. SIMULATION In this section, I quantitatively study the dynamics of variables in the model under different labor market conditions to see the effect of the heterogeneous wage contracts on the macroeconomic volatility in an economy with a financial fragility. To do so, I firstly set the parameter values, then I observe impulse responses of the equilibrium dynamics to domestic productivity shock under different degrees of the labor market friction. The baseline model is associated with the low level of elasticity of substitution between two types of workers, 1 1  − , and the low level of shares of regular workers firms’ production process,  . Then I change these two key parameters to the higher levels to observe how the changes of those values affect the dynamics of impulse responses. 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First version received on 12 October 2016 Peer-reviewed version received on 4 December 2016 Final version accepted on 27 June 2017 © 2017 EAER articles are distributed under the terms of the Creative Commons Attribution 4.0 International License (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted use, distribution, and reproduction in any medium, provided you give appropriate credit to the original author(s) and the source, provide a link to the Creative Commons license.