Wage Formation under Low Inflation

Abstract

This paper reviews the literature on the effects of low steady-state inflation on wage formation, focusing on four different effects. First, under low inflation, downward nominal wage rigidity (DNWR) may prevent real wage cuts that would have happened had inflation been higher. Second, wages (and prices) are given in nominal contracts, and inflation affects both how often wages are adjusted, and to what extent wages are set in a forward-looking manner. Third, incomplete labour contracts may provide workers with scope for inflicting costs on the firm without violating the contract, thus forcing the firm to accept a rise in nominal wages. Fourth, if effort depends on wages relative to a reference level, and workers and firms underweight inflation when updating the reference level, positive but moderate inflation may reduce wage pressure. The paper ends by a brief survey of empirical evidence, and a discussion of whether labour markets may adapt to a low inflation environment.

The US Wage Phillips Curve across Frequencies and over Time*

“…Explanations of this unusual relationship generally focus on the wage and price‐setting behaviour of firms and unions. The recent literature on the wage and price‐setting behaviour analyses the consequences of a low inflation environment on the wage formation process (see Holden, 2005, for a review of the literature). In particular, in the literature on near‐rational wage and price setting (e.g.…”

How Strong is the Case for Downward Real Wage Rigidity?

“…As a theoretical framework for the empirical exercise, we formulate a simple model of firm-level wage bargaining, where loss aversion with respect to past real wages is the source of drwr. The formulation draws upon Bhaskar (1990), Driscoll andHolden (2004), and, in particular, McDonald andSibly (2005). We have chosen a union-firm framework, partly because in most oecd countries, the majority of the workforce is covered by collective bargaining agreements.…”

“…Most previous work on downward wage rigidity has focused on downward nominal wage rigidity, dnwr (see surveys in Camba-Mendez, Garcia andPalenzuela, 2003, andHolden, 2004 There are also several other reasons for why we would expect real wages to be rigid downwards, as discussed in sections 2 and 3. Thus it seems necessary to explore the existence of drwr.…”

How Wages Change: Micro Evidence from the International Wage Flexibility Project

“…A key question in the theoretical and empirical literature, as reviewed in Camba-Mendez, García and Rodríquez Palenzuela (2003) and Holden (2004), is the extent to which job stayers resist wage cuts -that is, the extent to which downward wage rigidity exists. These studies have yielded remarkably inconsistent findings, both across different countries and across different datasets for the same country.…”