Wage growth and the inflationary process: a reexamination.

• Author: Darrat, Ali F.

1. Introduction

   The nature of the relationship between wage growth and inflation has long been the subject of on-going debate. The expectations-augmented Phillips-curve theory contends that the two variables are mutually causal. However, the original wage-type Phillips-curve model argues it is inflation that causes wage growth rather than vice versa. The price-markup scheme holds an opposite view and asserts that wage growth plays an independent causal role in the inflationary process. Of course, other theories (e.g., the monetarist) deny the presence of any reliable linkage between wages and prices.

   Researchers have also expended enormous effort attempting to investigate empirically the relationship between wage growth and inflation, but with mixed results. For example, Mehra [24] and Ashenfelter and Card [1] report results suggesting a bidirectional causality; Barth and Bennett [2] and Stein [37; 38] find causality running from prices to wages without feedback; while Shannon and Wallace [34] and Hill and Robinson [19] report results showing causality only in the reverse direction, from wages to prices. Still, Gordon [11], Bazdarich [4], Batten [3], and Mehra [27] find no causal linkage between the two variables. Clearly, such remarkably mixed evidence is unfortunate in light of the profound implications that the precise wage/price relationship may have for economic and public policy.

   A more recent and quite interesting study is that of Mehra [28]. Mehra employed the technique of cointegration and error-correction modelling on U.S. quarterly data for the period 1959:1-1989:3. He concluded that inflation and wage growth are cointegrated, implying that their long-run movements are correlated as the expectations-augmented Phillips-curve theory predicts. However, contrary to this theory, and in accordance with the original wage-type Phillips-curve view, Mehra argued that the inflation-wage growth long-run correlation is primarily the outcome of the former causing the latter.

   Mehra's model encompasses three basic variables; namely, prices (p), productivity-adjusted wages (w), and an output-gap proxy (g).(1) He tested each of the three variables (in logs) for the presence of unit roots, finding evidence of two unit roots in p and w, but a single unit root in g. Mehra then examined cointegration of the two variables having two unit roots (p, w). His results suggest that first-differences (but not levels) of prices and wages are cointegrated. Following Granger [14; 15], this finding if valid implies an error-correction model for inflation and wage growth and the presence of a Granger-causation between the two variables, at least in one direction. As mentioned, Mehra's results suggest that Granger-causality exists, but only from inflation to wage growth.

   While interesting, Mehra's cointegration inferences may suffer from a serious omission-of-variable problem potentially biasing his results. Granger [15] has shown that cointegration and Granger-causality are closely related concepts. As such, cointegration tests may also be sensitive to the omission-of-variables phenomenon discussed by Lutkepohl [22] for Granger-causality tests. It is well-known that causality (and, by extension, also cointegration) inferences in a trivariate inflation model are not necessarily robust to inclusion of other relevant macroeconomic variables that could influence inflation. Interestingly, cointegration results recently reported by Miller [29] indicate that omission of important variables from a basic model did significantly distort his cointegration findings.

   Literature on inflation provides a logical extension to Mehra's model. In particular, three additional variables appear potentially important for the inflationary process: namely, money supply, foreign exchange rate, and interest rates. The quantity theory of money places substantial weight on monetary changes in determining growth in aggregate demand and thus inflation. Empirical support of this monetarist view of inflation is overwhelming, as exemplified in the work of Fama [8], Dwyer and Hafer [5], and Hallman, Porter and Small [17]. In fact, in other studies, Mehra [25; 26; 27] also reports results indicating the significant role of money growth in the U.S. inflationary process.

   A theoretical basis for linking inflation to exchange rates can be found in the theory of purchasing power parity [9; 12; 30]. Several empirical studies have uncovered significant relationships between movements in the dollar's exchange rate and U.S. price behavior, especially since the advent of the floating exchange rates in 1973. Examples include Sachs [31], Solomon [36], Whitt, Koch and Rosenweig [41], and Himarios [20]. Finally, for models of nominal income and its components (e.g., prices), Sims [35] strongly recommends the inclusion of interest rates. Several empirical studies have confirmed Sims's contention, including Fackler [7], Litterman and Weiss [21], and Stock and Watson [39]. Furthermore, Mehra [27] also finds evidence of the importance of interest rates (and money growth) in determining U.S. inflation.

   The preceding discussion suggests the appropriateness of testing a general inflation model that encompasses the possible roles of money supply, foreign exchange rates and interest rates along with the two factors examined by Mehra [28]; namely wages and the output gap.(2)

   The main purpose of this paper therefore is to reexamine Mehra's conclusions regarding the wage-price causal linkage in the context of a broader model. The empirical results from cointegration tests and the implied error-correction representation significantly alter Mehra's results and indicate their fragility to the omission of important variables. The following section discusses the results from unit-roots and cointegration tests. Next, findings for Granger-causality are analyzed. Concluding remarks are offered in the final section.

2. Test Results for Unit Roots and Cointegration

   Following Mehra, I employ the augmented...