Writing Assignment #3:
Thee Downward Rigidity of wages
This paper answers the following questions prtaining to the downward rigidity of wages: (1) If prices are broadly flexible, wages are flexible upward, but wages are sticky downward, what are the implications for how long it takes the economy to return to full-employment equilibrium when there is a recessionary gap versus how long it takes to close an expansionary gap?; and (2) Suppose the government sets tax rates and transfer payment eligibility requirements so that the budget is balanced when the economy is at full employment, in surplus when inflationary gaps are present, and in deficit when recessionary gaps are present. If wages are flexible upward, but sticky in the downward direction, how will this affect the government’s ability to maintain a cyclically-balanced budget (compared to the case where wages are equally sticky in both directions)?
A situation wherein wages are flexible going upward but sticky going downward has been observed in the baking company Hostess (and this phenomenon has been observed also more broadly within US). As presented in the case, the union members were unwilling to accept a contract indicating reduced benefits for them. The members’ complaint was the recent increases in pay and benefits of the managers; but these managers are unwilling to accept similar reduced benefits as the union members; hence the delay in union negotiation. This situation obviously indicates a situation of downward wage rigidity.
Daly, Hobijn and Lucking described downward wage rigidity as “the inability of employers to reduce nominal pay” (1). Given this downward wage rigidity, the implications for how long it takes the economy to return to full-employment equilibrium when there is a recessionary gap are more pronounced and prolonged than when closing an expansionary gap. An expansionary shock in the economy tends to increase the price level, which in turn reduces the real wage in the short run. In relation to labor contracts, if the price level over the term of the contract is higher than what is expected by the workers, the actual real wage will be less than the expected real wage. The reduced wage encourages employers to hire more workers thereby producing more output (above full equilibrium), resulting to an expansionary gap. But this gap will only be a temporary situation. Since prices and wages are flexible to move upward, price level expectation and nominal wages will be revised upward, thereby closing the gap. M Meanwhile, wages are prone to downward rigidity hence the economy tends to fall far below full employment during recession. Firms tend to cut production and offer less employment as nominal wages fail to adjust downward. Because of the downward wage rigidity, it is possible for the economy to become stuck far off full employment for very long periods of time (e.g. Great Depression). According to Daly, Hobijn and Lucking, the downward rigidity in wages can lead to misallocation of resources in the economy especially in low-inflation countries. Firms deal with wage rigidity by changing production and employment. So when there is a fall in aggregate demand (in the case of recession), firms resort to layoffs and production cuts. As workers lose jobs they cut their spending – even the workers who are still employed will spend less out of concern for future job cuts. As consumer spending drops, more firms layoff even more workers. The economy will come to equilibrium that is far below full employment and remain there for an extended period of time.
The Keynesians reject tax financing. Instead they want the government to balance the budget over the business cycle – running deficits and borrowing the money during recessions while running surpluses and paying the debt off during booms. The surpluses should roughly cancel the deficits - this is known as balancing the budget over the business cycle. It does not quite work that well, because of downward sticky wages and prices the economy is more prone to recessions than booms so surpluses will not be large enough and frequent enough to pay the deficits off.
Daly, Mary, Bart Hobijn and Brian Lucking. “Why Has Wage Growth Stayed Strong?” Economic Letter. 2 April 2012. Federal Reserve Bank of San Francisco. http://www.frbsf.org/publications/economics/letter/2012/el2012-10.html