Wage Flexibility and Macroeconomic Stability: Insights from an Upgraded TANK Model

What are the effects of a higher degree of wage flexibility on macroeconomic stability? Recently, renewed interest in this classic question has emerged in the heterogeneous-household literature. In a standard two agent New Keynesian (TANK) model proposed in Diz et al. (2023), hand-to-mouth agents rely solely on labor income, so that conditional on demand shocks, a higher degree of wage flexibility leads to larger fluctuations in consumption and aggregate output. However, and building on the insights of Debortoli and Galí (2024), we suggest to use an upgraded TANK model that delivers a more nuanced representation of hand-to-mouth consumption patterns: Aside from labor income, hand-to-mouth households receive a fraction of firm profits, must pay interest on their debt, and are less productive than unconstrained households. We demonstrate that once these features are introduced, greater wage flexibility reduces the volatility of output conditional on a demand shock across a wide range of plausible parameter values, and we use our model to shed light on the mechanisms driving this result.