Asymmetric nominal flexibility and economic fluctuations.

• Author: Kandil, Magda

1. Introduction

   Recent research has produced strong evidence that supports the asymmetric effects of positive and negative money supply shocks. Using quarterly data for the United States, the evidence of Cover [10] suggests that positive money supply shocks do not have an effect on output while negative money-supply shocks do. The asymmetric impact of demand shocks on real output growth is not addressed in the context of mainstream business-cycle theories which include the equilibrium explanation pioneered by Lucas [21] and neo-Keynesian models emphasizing nominal wage rigidity [14; 15] or price rigidity [2].

   In the context of Lucas's paradigm, agents are scattered in informationaly isolated islands across the economy. An unexpected, positive or negative, change in aggregate demand may be misperceived by agents as being specific to their markets. In the case of a positive demand shock, producers and workers expand the output and labor supplied to take advantage of the perceived increased demand in their island. Similarly, agents are expected to contract the output produced in response to a perceived reduction in the demand for their output. This scenario does not provide an obvious theoretical channel through which the slope of the short-run supply curve can be differentiated depending on the direction of the change in aggregate demand.

   In the context of a contractual wage rigidity framework, the nominal wage is fixed for a duration that is determined by contractual agreements. According to this framework, a change in aggregate demand deviates the real wage from its market clearing value for a duration that is determined by the contract length. A positive demand shock will raise the price level, decrease the real wage and, in turn, cause an expansion in labor demand and the output produced in the short-run. A negative demand shock, in contrast, raises the realized real wage which has a negative impact on labor demand and the output produced in the short-run. In the absence of any stipulation in contracts that differentiates the degree of wage rigidity in response to a positive and negative demand shock, the slope of the short-run supply curve is not likely to be differentiated based on the direction of change in aggregate demand.

   In the context of the sticky-price explanation of business cycles, the price level across sectors of the economy is fixed for a specific duration. A change, positive or negative, in aggregate demand will be absorbed in output as long as the price level remains fixed in the short-run. In the absence of any stipulation that differentiates the upward and downward stickiness of the price level, the slope of the short-run aggregate supply curve is not likely to be differentiated based on the direction of change in aggregate demand.

   These implications appear in sharp contrast to the empirical evidence of Cover [10].(1) A positive demand shock appears to be operating along a very steep (or may be a vertical) short-run aggregate supply curve. In contrast, a negative demand shock appears to operate along a very flat (or may be a horizontal) short-run supply curve. Such evidence requires an adequate explanation. This paper focuses on a possible explanation that relates to observed asymmetry in price and wage flexibility in the real world.(2) If wages and/or prices are rigid in the downward direction and flexible in the upward direction, the asymmetry exacerbates the positive effects of demand shocks on wage and price inflation and the contractionary effects of negative shocks on real output growth.

   The focus of this paper is on two theoretical explanations of asymmetric nominal flexibility. Sticky-wage contracting models propose asymmetric wage indexation as a possible explanation of the asymmetric flexibility of wages and prices. On the other hand, theoretical efforts advocating sticky prices propose the asymmetric adjustment of prices to provide an explanation for asymmetric flexibility. Determinants of nominal flexibility as well as its implications vary across these alternatives. The empirical investigation of the paper will draw on these differences in an effort to verify the empirical validity of the competing explanations. In addition, the investigation will analyze hypotheses that differentiate the implications of asymmetric nominal flexibility from other alternatives emphasizing the asymmetry of demand shifts. Towards these objectives, the analysis will provide time series evidence of the asymmetric effects of a major source of demand shocks, unanticipated growth of the money supply, on real output growth and wage and price inflation across a sample of nineteen industrial countries. Cross-country analysis of the asymmetric effects of monetary shocks will provide the paper's findings on the empirical validity of the proposed explanations for asymmetric economic fluctuations.

   The remainder of the investigation is organized as follows. Section II provides a brief reference to two possible theoretical scenerios advocating asymmetric nominal flexibility. Section III draws hypotheses for the empirical analysis and describes the data and econometric methodology. Section IV presents the basic evidence on asymmetric nominal flexibility and its accompanying effects. Section V tests the validity of the theoretical predictions concerning determinants of asymmetric flexibility and its implications. A summary and conclusion are provided in section VI.

2. Theoretical Hypotheses

   In this section, two possible explanations for the asymmetric flexibility of wages and prices are outlined briefly.

   Asymmetric Wage Indexation

   A simple and intuitive explanation for the observed asymmetry in economic fluctuations can be traced back to conditions in the labor market concerning wage indexation. Kandil [19] explores a possible scenerio for asymmetric indexation and its accompanying impacts.(3)

   Assume wage and salary negotiations across the economy are governed by contractual agreements of the form specified in explicit contracts [16] or implicit contracts [22]. All contracts specify a contract length and a path of nominal wages based on information available at the time contracts were negotiated. In addition, each contract stipulates an indexing parameter that allows for an additional adjustment of the nominal wage. This adjustment is contingent on unexpected changes in the price level that are realized after contracts are negotiated.

   In this framework, it is possible to introduce asymmetry by allowing indexation to vary depending on the direction of demand shocks. The degree of indexation may be larger in response to positive demand shocks compared to negative shocks. There are two possible explanations for this asymmetry.

   The asymmetric flexibility of wages may be the result of institutional settings that differentiate wage and salary negotiations in the upward and downward directions. During boom periods, cost of living adjustments may be specified to guarantee workers upward adjustment of wages to keep up with inflation. In contrast, firms may be reluctant to take aggressive measures towards adjusting wages in the downward direction during recessionary periods. This is because the search and training cost of hiring new workers to accommodate a future rise in demand may actually exceed the perceived loss of retaining workers at wages that exceed the marginal physical product of labor during recessionary periods.

   Alternatively, the asymmetric flexibility of wages may be an endogenous response to uncertainty impinging on the economic system. Models of the variety of Gray [15] have emphasized the dependency of the degree of indexation on the variability of stochastic disturbances. In a situation where positive and negative shocks are not equally variable, agents' incentives for the optimal degree of indexation would be asymmetric. For example, in economies that have experienced a history of high inflation, positive demand shocks are more dominant in the stochastic structure of the economic system. This, in turn, is likely to increase agents' incentives for the upward adjustment of wages in response to positive demand shocks that are realized after contracts are negotiated.

   Asymmetric wage indexation will differentiate the slope of the aggregate supply curve based on the direction of demand shocks. In a scenario that assumes a larger indexing parameter in the upward direction, positive demand shocks will prompt instantenous upward adjustment of wages. Thus, the increased demand will be reflected in a higher cost of the output produced and, in turn, higher prices. That is, the shock will move the economy along a vertical or a very steep supply curve. In contrast, if wages are rigid in response to negative demand shocks (i.e., a small or a zero indexing parameter in the face of negative demand shocks), the negative effects of these shocks on labor employment and output are exacerbated with minimal effects on the cost of the output produced and prices. Thus, negative demand shocks will move the economy along a horizontal or a very flat supply curve.

   Demand shocks are distributed with a zero mean and a constant variance. This variance determines the dispersion of realized demand shocks around its mean value. The larger the variance, the greater is the impact of positive and negative demand shocks on the economy. If wages are more flexible in the upward direction, negative demand shocks will have a larger effect on real output compared to positive demand shocks. Accordingly, the increased variability of demand shocks is expected to have a negative impact on the average growth of real output under this scenario. In contrast, positive demand shocks will have a larger effect on wage and price inflation compared to negative demand shocks. Accordingly, the increased demand variability is likely to induce a larger positive impact on average inflation when wages and prices are more flexible in the upward...