Steinar Holden 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 ?

Steinar Holden 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?

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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)

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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

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The standard model with no DNWR Real wage

Employment N

Wage curve

N*

Price curve

Steady-state inflation has no effect on eq. employment

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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 => workers have a strategic disadvantage– under negative inflation, firms must persuade workers to accept

wage cut => the firm has a strategic disadvantage

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DNWR and low steady-state inflation

Real wage

Employment N

Wage curve, low inflation

Wage curve, high inflation

NL NH

Price curve

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The long run Phillips-curve

Inflation

Unemployment UL UH

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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 + ε, which gives higher payoff to workers than a strike does => workers will accept

• Bargaining outcome is 95 + ε, and no strike takes place

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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 - ε, which gives higher payoff for firm than a lock-out does => firm will accept

• Bargaining outcome is 105 + ε, and no lock-out takes place

• Bargaining outcome depends on initial wage => high inflation erodes value of old contract and weakens workers.

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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

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

A: Base case-stylised Europe

-0,04-0,03-0,02-0,01

00,010,020,030,040,050,06

0 0,02 0,04 0,06 0,08 0,1 0,12

Unemployment

Infl

atio

n

D: Stylised US, γ = 0.15, z = 0.01

-0,04-0,03-0,02-0,01

00,010,020,030,040,050,06

0 0,02 0,04 0,06 0,08 0,1 0,12

Unemployment

Infl

atio

n

• 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

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Long run Phillips-curve (Holden, Economica, 2004)

E:Lock-out more costly, λL = 0.8

-0,04-0,03-0,02-0,01

00,010,020,030,040,050,06

0 0,02 0,04 0,06 0,08 0,1 0,12 0,14 0,16

Unemployment

Infl

atio

n

F: No productivity growth, α = 0

-0,04-0,03-0,02-0,01

00,010,020,030,040,050,06

0 0,02 0,04 0,06 0,08 0,1 0,12

Unemployment

Infl

atio

n

G: Holdout not costly, κ = 0

-0,04-0,03-0,02-0,01

00,010,020,030,040,050,06

0 0,02 0,04 0,06 0,08 0,1 0,12

Unemployment

Infl

atio

n

H: EMU

-0,04-0,03-0,02-0,01

00,010,020,030,040,050,06

0 0,02 0,04 0,06 0,08 0,1 0,12

Unemployment

Infl

atio

n

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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

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Norway – individual nominal wage changes for white-collar workers in 1996

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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

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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”

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The long run Phillips-curve

Inflation

Unemployment UL UH

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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

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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)

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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)

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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: Lundborg&Sacklèn (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

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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

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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

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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

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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).

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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)