Are the income policy agreements of 1992-93 in Italy still valid? Towards a theory for the optimal design of the “social pact” in the EMU

This contribution studies the macroeconomic implications of a “social pact” among the government, trade unions and employers’ associations aimed at keeping the growth in domestic wages and prices in line with the government’s inflation target. Such a tri-partite pact captures the main characteristics of the collective wage bargaining setup as reformed in Italy during the 1990’s. Drawing on a simple model characterised by monopoly distortions in labour and goods markets, we show that a social pact designed on an ideal inflation target is unable to bridge the output gap completely. We find that despite the income policy agreement, a coordination failure with the common central bank may still materialise, leading the economy to an equilibrium characterised by an inflationary (or a deflationary) bias. We further show that the first best outcome can be replicated when the government simply targets union-wide inflation.