Sticky wage or sticky price? Analysis of the cyclical behavior of the real wage.

• Author: Kandil, Magda

1. Introduction

   The study of business cycles has been at the heart of macroeconomic theory for decades. Theoretical efforts have focused on providing an adequate explanation for sources of economic fluctuations. New Keynesian explanations have emphasized rigidity that interferes with market forces, increasing the effect of demand shocks on the output produced. The form of rigidity is in sharp contrast between sticky-wage and sticky-price models. The former imposes rigidity on the short-run adjustment of wages to demand shocks [20; 47]. The latter, in contrast, imposes rigidity on the short-run price adjustment to demand shocks [2; 34; 40; 9; 43; 4].

   The theoretical plausibility of competing explanations of business cycles has stimulated interest to establish their empirical validity. [32; 28; 1; 8; 11; 23; 21; 26]. These efforts have focused attention on cyclical fluctuations of the real wage in response to demand shocks. The real wage may move procyclically or countercyclically according to the relative adjustment of wages and prices. The interest in studying the cyclical behavior of the real wage relates to its implications to the real effects of aggregate demand shocks. In the context of sticky-wage models, nominal wage rigidity reinforces the countercyclical response of the real wage to demand shocks and the real effect of these shocks on output growth. Sticky-price models, in contrast, advocate that price rigidity increases the procyclical response of the real wage to demand shocks and their real effect on output growth.(1)

   The results of earlier investigations of the cyclical behavior of the real wage appear conflicting and, therefore, do not lend support to a given explanation.(2) The present investigation seeks to contribute to this literature. Unlike previous empirical research on the subject, the objective of this investigation is to study the cyclical behavior of the real wage and the relative flexibility of the nominal wage and the price level that determines this behavior in response to demand shocks. Using data for the United States in the pre- and post-World War II sample periods, the cyclical behavior of the real wage varies in response to demand shocks over time. It is also evident that the cyclical behavior of the real wage appears asymmetric in response to the positive and negative components of demand shocks.

   Variation in the cyclical behavior of the real wage provides the basis for the paper's investigation of the empirical validity of the sticky-wage and sticky-price explanations of business cycles. First, the paper will investigate factors that underlie the observed variation in the cyclical behavior of the real wage: sticky wage and/or sticky price. Having identified these factors, the investigation will evaluate the correlation between the cyclical behavior of the real wage and the response of real output to demand shocks. This correlation plays a key role in differentiating the implications of the contending explanations. The results highlight the importance of rigidity in the labor and product markets to the cyclical behavior of the real wage and accompanying output fluctuations.

2. Rigidity in Labor and Product Markets: Two Theoretical Views

   To motivate the empirical investigation of the paper, this section offers a quick refresher background of two competing explanations for demand-driven economic fluctuations. The common theme that underlies these explanations is some sort of market failure that deviates the economy from its optimal response to changes in tastes and technology. The failure is based on rigid wages and/or prices.

   A Sticky Wage New-Keynesian Explanation

   Sticky-wage new-Keynesian models have emphasized rigidity in the labor market to explain economic fluctuations. Labor contracts specify in advance the nominal wage that prevails for the contract duration. Contracts may be explicit formal agreements as in [20; 47] or implicit informal agreements of the form specified in [33].

   Assume wage and salary negotiations across the economy are governed by contractual agreements. All contracts specify a contract length and a path of nominal wages based on available information at the time contracts were negotiated. Negotiating contracts entails a fixed cost. In deciding on the optimal contract length, agents compare these costs to the benefits of more frequent recontracting. An increase in aggregate uncertainty increases the risk of fixing the nominal wage and decreases agents' incentives to write long contracts.

   Following contracts' negotiation, a positive disturbance to aggregate demand raises the price of the output produced. In the absence of any stipulation for wage indexation, the increase in price lowers the real product wage faced by firms, causing it to fall below its market clearing value. The fall in the real wage, in turn, causes output and employment to rise above their natural (full-equilibrium) levels. The increased output moderates the necessary price adjustment to clear the product market following the rise in demand.

   It is possible, however, that nominal wage flexibility may be asymmetric in response to positive and negative demand shocks. Assume each contract stipulates an indexing parameter that allows for an additional adjustment of the nominal wage in response to unexpected changes in the price level that are realized after contract negotiation. The degree of indexation may be larger in response to positive demand shocks compared to negative shocks.(3) The asymmetric flexibility of wages may be the result of institutional settings that differentiate wage and salary negotiations in the upward and downward directions. 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 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 aggregate uncertainty. Models of the variety of [20] have emphasized the dependency of the degree of indexation on the variability of stochastic disturbances. For example, in economies that have experienced a history of high inflation, agents have larger incentives for the upward adjustment of wages.

   In a scenario that assumes a larger indexing parameter in the upward direction, positive demand shocks will prompt instantenous upward adjustment of wages. Wage indexation moderates, therefore, the countercyclical response of the real wage to positive demand shocks and the positive effect of the increased demand on the output supplied. Consequently, the increased demand will be reflected in a higher cost of the output produced and, in turn, higher prices. In contrast, if wages are more rigid in response to negative demand shocks (i.e., a small or a zero indexing parameter in the face of negative demand shocks), the countercyclical response (increase) of the real wage increases the contractionary effect of negative shocks on output and moderates the deflationary effect on prices.

   A Sticky-Price New-Keynesian Explanation

   Sticky-price models [2; 34; 40; 9; 43; 4] have emphasized rigidity in the product market to explain economic fluctuations. Monopolistically competitive firms face small "menu costs" when they change prices. These are resources involved in changing prices. In deciding on the frequency of price adjustment, firms compare the menu cost to the benefits of more frequent price adjustment. An increase in uncertainty increases the risk of fixing prices and increases firms' incentives to pay the menu cost.

   Assume each market in the economy contains imperfectly competitive firms that change prices at discrete intervals. Each firm sets its price to the average of its expected profit maximizing prices for the period when the price will be in effect. Firms opt to change the output produced in response to demand shocks that are realized after prices have been set. A positive disturbance to aggregate demand raises the output produced. Assuming a Walrasian labor market, the increase in labor demand increases the nominal wage in the labor market, causing a rise in the real wage.(4)

   It is possible, however, that price flexibility may be asymmetric in response to positive and negative demand shocks.(5) Positive trend inflation plays a key role in introducing asymmetries. Inflation causes firms' relative prices to decline automatically between adjustments. This requires greater adjustment of firms' desired prices in the face of positive shocks than negative shocks. When a firm wants a lower relative price (in the face of a negative demand shock), inflation does much of the work, decreasing the need to pay the menu costs to adjust prices. By contrast, inflation decreases the firm's relative price when firms actually desire a higher price in the face of positive shocks, creating a large gap between desired and actual prices.

   Asymmetric price adjustment implies that shifts in aggregate demand have asymmetric effects on output. Since prices are sticky downward, a fall in aggregate demand reduces output and decreases the real wage substantially. In contrast, the increased upward flexibility of prices moderates the increase in real output and the rise in the real wage in response to positive demand shocks.

3. Empirical Models and Theoretical Hypotheses

   The starting point for the investigation of theoretical differences is the specification of empirical models for the cyclical behavior of the real wage and accompanying fluctuations. Stationary is tested following the suggestions of [37]. Based on the results of the Dickey-Fuller test [17], stationarity of the variables under investigation is rejected. Given these results, the empirical models are specified in first-difference form as follows:

   (1) [Drw.sub.t] = [a.sub.0] +...