Wage formation under low inflation

1
Wage formation under low inflation

• EMU entails ambitious target for price stability,
  which gives limited scope for nominal wage growth
• What are the possible implications of low
  inflation on unemployment and wage rigidity ?

2
Effects of steady-state inflation on wage setting

• Downward nominal wage rigidity push up wages
• Staggered wage contracts
• trend inflation affects frequency and degree of
  forward-lookingness of staggered wages
• Near-rational wage setters
• Effort depends on reference wage
• Wage setters neglect low inflation, reducing wage
  pressure
• A floor to nominal wage growth
• incomplete contracts provide workers with scope
  to inflict costs on firm even under existing
  contract
• multi-level wage setting
• Evidence on long run inflation unemployment
  tradeoff
• Will labour markets and wage setting institutions
  adapt?

3
Downward nominal wage rigidity DNWR

• Tobin (AER, 1972) - DNWR leads to higher
  unemployment at low inflation
• Co-ordination failure and concern for relative
  wages (Keynes, 1936)
• Fairness
• Survey evidence nominal wage cuts viewed as
  unfair even in situations where the same real
  wage reduction would be viewed as fair if caused
  by price increase (Shafir et al, QJE, 1997,
  Bewley, 1999)
• Experimental evidence Fehr and Tyran (AER, 2001)

4
Explanations of DNWR (cont.)

• Legal restrictions
• Nominal wages given in contracts that can only be
  changed by mutual consent (MacLeod and Malcomson,
  AER, 1993, Holden, EER, 1994).
• Firms must force workers/unions to accept wage
  cut by threats of layoffs, lock-out, closing down
  plant, etc
• Such contracts are closely related to employment
  protection legislation may prevent holdup
  inefficiency
• U.S. law different workers viewed to accept wage
  cut if they show up at work

5
The standard model with no DNWR
Steady-state inflation has no effect on eq.
employment
6
Effects of DNWR on aggregate employment

• Akerlof, Dickens and Perry (ADP) (1996)
• DNWR justified by fairness considerations
• Simulation model based on monopolistic
  competition with wage and price setting, DNWR and
  firm-specific shocks
• Under low inflation, DNWR will push up wages in
  firms experiencing negative shock
• Holden (EER, 1994, Economica 2004)
• Invoke legal feature that nominal wages can only
  be changed by mutual consent
• Under positive inflation, workers must persuade
  firm to accept wage rise gt workers have a
  strategic disadvantage
• under negative inflation, firms must persuade
  workers to accept wage cut gt the firm has a
  strategic disadvantage

7
DNWR and low steady-state inflation
8
The long run Phillips-curve
9
Why does inflation put workers at a strategic
disadvantage?

• Assume wage outcome after strike or lock-out
  100
• Assume costs of strike or lock-out 5
• Old contract wage 90 (inflation reduced real
  value)
• Threat of strike is credible, as this gives
  higher payoff to the workers (100 5 95) than
  the initial wage of 90
• But firm can offer 95 e, which gives higher
  payoff to workers than a strike does gt workers
  will accept
• Bargaining outcome is 95 e, and no strike
  takes place

10
Strategic effect of inflation cont.

• Old contract wage 110
• negative inflation or negative shock implies that
  wage must go down
• Threat of lock-out is credible, as this gives
  higher payoff to firm (100 5 105) than
  initial wage does
• But workers can offer 105 - e, which gives
  higher payoff for firm than a lock-out does gt
  firm will accept
• Bargaining outcome is 105 e, and no lock-out
  takes place
• Bargaining outcome depends on initial wage gt
  high inflation erodes value of old contract and
  weakens workers.

11
DNWR in organised and unorganised sector (Holden,
Economica, 2004)

• Collective agreements can only be changed by
  mutual consent
• Workers resistance to wage cuts (DNWR) depends
  among other things on collective agreement
  legislation
• Individual labour contracts European law holds
  that mutual consent is required to change
  contract (US law firm may impose cut
  unilaterally)
• resistance to wage cuts (DNWR) depends on
  strength of employment protection legislation
  (EPL)
• DNWR likely to be stronger in organised sector

12
Simulation of long-run Phillips-curve (Holden,
Economica, 2004)

• Firm-specific shocks causes changes in relative
  wages
• Two percent annual growth in labour productivity
• Two percent increase in nominal wages in
  organised sector unless firms threaten to use
  lock-out (due to work-to-rule or go-slow threats
  by workers)
• Stronger DNWR in Europe due to higher bargaining
  coverage and stricter EPL

13
Long run Phillips-curve (Holden, Economica, 2004)
14
Empirical studies documenting DNWR

• Fehr and Goette (2000) for Switzerland,
• Christofides/Leung (1999), Fortin/Dumont (2000)
  for Canada,
• Agell with co-authors (Lundborg, Bennmarker) for
  Sweden,
• Kimura and Ueda (1997) for Japan,
• Nickell and Quintini (2001) for the UK,
• Altonji and Devereux (1999), Lebow et al (2003)
  for the US
• Dessy (2002), Knoppik and Beissinger (2005) for
  EU countries
• Holden and Wulfsberg (2005) for OECD countries
• Increasing in strictness of EPL and in union
  density,
• decreasing in unemployment

15
Norway individual nominal wage changes for
white-collar workers in 1996
16
Effects of inflation on staggered wage contracts

• Ball, Mankiw, Romer (1988) high inflation leads
  to more frequent wage adjustment and thus less
  persistence
• Ascari (2000) high inflation increases the
  degree of forward-lookingness in wage setting,
  and thus reduces persistence
• Karanassou, Sala and Snower (2003)
• Time discounting implies that last part of
  contract period is less important
• Wages and prices will lag behind money growth.
  Thus inflation reduces wage and price pressure,
  increasing aggregate employment
• Long run tradeoff between inflation and
  unemployment

17
Near-rational wage setters (ADP, 2000)

• Workers effort depends on wage relative to
  reference level
• Near-rational workers and firms will underweight
  inflation in the updating of the reference wage
• No underweighting of inflation for zero inflation
  or for high inflation (underweighting too costly)
• Underweighting of inflation, and thus lower wage
  pressure, for low rates of inflation
• Blinder Price stability is so low inflation
  that it ceases to be a factor in influencing
  decisions

18
The long run Phillips-curve
19
A floor to nominal wage growth

• Incomplete contracts and work-to-rule (Moene, EJ,
  1990, Holden, Economica, 1989, OEP, 1997)
• workers may inflict costs on firm even under
  existing contract, e.g. by strictly adhering to
  working rules
• firm may reduce bonus payments etc
• if workers can inflict larger costs on firm than
  vice versa, nominal wages will increase
• the floor to nominal wage growth is lowered by
  increasing bonus payments and other types of
  flexible remuneration

20
Multi-level wage setting and inflation - I

• Central wage setters want wage moderation but
  DNWR prevails
• Wage growth at local level (wage drift) due to
  work-to-rule
• Under high inflation, there is room for both
  central wage increase and wage drift DNWR does
  not bind
• Multi-level wage setting implies wage moderation
• Under low inflation, wage drift leaves no room
  for central wage increase DNWR binds
• Multi-level wage setting implies strong wage
  pressure
• Rødseth (1985), Rødseth and Holden (1990),
  Calmfors (1993),
• Holden (1998) formalisation and evidence for
  1961-1985/92 a floor to nominal wage growth at
  central level 1.5 (Denmark) to 3.9 (Sweden)

21
Multi-level wage setting and inflation version
II

• Central wage setters want wage moderation
• Solidaristic wage setting compression of
  relative wages at the central level
• Wage growth at local level (wage drift) necessary
  to restore relative wages to market values
• Multi-level wage setting requires high inflation
  and devaluations
• Without solidaristic wage setting, less need for
  inflation
• Hibbs and Locking (LE, 1996), Iversen (1999)

22
Evidence of permanent tradeoff between inflation
and unemployment

• Standard view no such tradeoff exists
• Yet considerable evidence in favour of a
  permanent tradeoff between inflation and
  unemployment
• Panel of EU-countries Karanassaou et al (2003a)
• The US Akerlof et al (1996), Karanassou (2003b),
  Ahmed and Rogers (JME, 2000)
• Sweden LundborgSacklèn (2001)
• Bullard and Keating (JME 1995) significant
  long-run positive response of real output to
  inflation in European countries with low
  inflation in period 1960-90

23
Will labour markets and wage setting institutions
adapt to low inflation?

• Under low inflation, nominal wage cuts will be
  more frequent, and thus no longer be viewed
  unfair (Mankiw 1996, Gordon,1996)
• But fairness and legal restrictions are
  complementary
• legal restriction prevent wage cuts from being
  frequent, preventing erosion of the fairness
  argument
• fairness argument prevents change of legal
  restriction

24
Will labour markets and wage setting institutions
adapt to low inflation? (cont)

• Firms are likely to change remuneration systems
  so as to increase flexibility
• reduces base wage to which DNWR applies
• improves firms bargaining position and reduces
  floor to wage growth
• Lebow et al (2000) US firms able to circumvent
  some, but not all, DNWR by varying benefits

25
Will labour markets and wage setting institutions
adapt to low inflation? (cont)

• Firms choice of contracts (Holden, 2001)
• Fixed wage contracts or temporary employment ?
• Fixed wage contracts provides incentives for
  investment and training
• Temporary employment facilitates efficient
  mobility
• Inflation erodes real value of fixed wage
  contracts over time, so that badly matched
  workers may quit
• Low inflation makes fixed wage contracts more
  rigid, but fewer firms will choose fixed wage
  contracts

26
Evidence of adaption to low inflation

• Switzerland early 1990s persistent DNWR in spite
  of low inflation and high and increasing
  unemployment (Fehr and Goette, 2001)
• Sweden early 1990s persistent DNWR in spite of
  high and increasing unemployment (Agell and
  Lundborg, 2003).

27
Concluding remarks

• Rigorous theoretical explanations for downward
  nominal wage rigidity (DNWR) (fairness and legal
  restrictions)
• Strong empirical evidence that downward nominal
  wage rigidity prevails in many countries
• Not clear at what rate of inflation DNWR will
  bite
• productivity growth provides room for nominal
  wage growth
• changes in relative wages requires aggregate wage
  growth
• reason to expect a floor on nominal wage growth
• Labour markets will adapt to some extent
• Evidence that DNWR is persistent even under high
  unemployment (Switzerland and Sweden)