RDP 2000-08: Nominal Wage Rigidity in Australia 2. The Rationale for Downward Wage Rigidity

In his presidential address to the American Economic Society in 1984, Charles Schultze emphasised that one of the main disagreements in macroeconomics is why nominal wages are sticky in the face of aggregate demand shocks (Schultze 1985). While a unified theory of nominal wage rigidity is yet to be developed (Stiglitz 1999), various schools of thought offer a rationale for observed stickiness in nominal wages.

A helpful starting point for explaining possible reasons for rigidity is to consider the kind of world in which perfect wage flexibility is a useful paradigm.^[3] This is a stylised world where goods and labour are homogeneous, economic agents are price takers, quantities adjust quickly, information is complete and expectations about future events can be formed from the recurrent nature of past events. Here, work effort can be easily monitored and valued, and workers are interchangeable, since their marginal revenue product is the same regardless of the firm to which they are attached. Finally, there is no advantage of continuity of association between workers and firms. Of course, in reality, each of these characteristics is usually violated in some way and, in consequence, wage rigidity is observed.

Most historical explanations of observed stickiness in nominal wages tended to rely on imperfect information in the form of money illusion, where workers resist nominal wage reductions but fail to perceive that inflation erodes real wages. This approach has been unappealing because it also implies irrationality.^[4] Keynes (1936) emphasised that because of imperfect mobility of labour, workers resist falls in nominal wages, since those who consent to such a reduction will suffer a fall in their relative real wage. Sociological studies have focused on the difficulty in assessing work effort and identify the perceived entitlements of workers and employers that determine ‘rules of fairness’ for the setting of wages (Kahneman et al 1986; Bewley and Brainard 1993).

Recourse to notions of fairness has, however, been criticised, not because of evidence against it, but because of its weak theoretical grounding. Consequently, New Keynesians have attempted to reconcile observed wage stickiness with rational optimising behaviour. Strictly speaking, their focus is on rational sources of real or relative wage stickiness, but it is often argued that these sources of rigidity also imply nominal wage stickiness.^[5] Some stem from the idea of an efficiency wage, where nominal wage cuts encourage adverse selection of inferior workers, shirking and excessive labour turnover, all of which detract from the efficiency of the firm. However, most sources of rigidity stem directly from the large returns to continuity of association between workers and firms.^[6] Realising the gains from these associations requires explicit or implicit contracts.

The existence of a wage contract that requires periodic renegotiation necessarily introduces inertia into wage movements, but this observed stickiness may be optimal for those who enter the contract. It may be optimal in the presence of risks, such as probable fluctuations in labour demand, for risk-neutral firms to offer insurance to risk-averse workers in the form of stable income. Alternatively, wage stickiness may be optimal in the presence of uncertainty. While some changes in economic conditions have a known probability at the time contracts are negotiated, others are not predictable, so it is in the interests of workers and firms to adjust wages after the size and permanency of the changes have been assessed. Consequently, nominal wages remain sticky, compared with the predictions of an auction market. But, even if the size and permanency of the change have been assessed, there are ‘menu’ costs associated with changing wages (sometimes referred to as ‘haggling’ costs).^[7] It is optimal for wages to be revised only when the benefits of such change exceed the costs associated with renegotiation.

Thus, for a host of reasons that may be optimal for individual agents, nominal wage rigidities can arise. The macro consequences, on the other hand, are clearly sub-optimal, especially when inflation is so low that the real effects of such rigidity are amplified. Understanding the nature and extent of nominal wage rigidity can, therefore, usefully inform monetary policy.

However, despite its importance, there has been very little exploration of nominal wage rigidity in Australia.^[8] Certainly, until recently, there has been a general lack of data with which to examine the dispersion of wage changes. This, combined with a history of centrally determined wages, had encouraged a presumption that nominal wages are highly rigid, at least downwards. But changes in the wage bargaining system that allow for more market-determined wage outcomes, combined with new sources of wage data, suggest that investigating the nature and extent of wage rigidity will be more fruitful. Furthermore, the shift to a low-inflation environment has made such an investigation more important.

In the following section, we draw on lessons from overseas studies of nominal wage behaviour, identify some of the measurement issues that can distort measured wage changes, and motivate the choice of data for our examination of the Australian experience.

Footnotes

Schultze (1985) provides a comprehensive review of the various strands of literature on implicit contracts and highlights their implications for wage rigidity. [3]

See Tobin (1972) for an historical perspective. [4]

There is considerable tension in the literature on this issue. Given sticky relative wages, aggregate nominal wages can vary if each wage is indexed to a nominal variable or if workers have rational expectations about the equilibrium path of aggregate nominal wages and change their wages accordingly. Consequently, New Keynesian theories of real wage rigidity do not have clear implications for nominal wages. However, as emphasised by Schultze (1985) and Blanchard (2000), if wages move sluggishly in response to the relative conditions facing individual firms, they will also move sluggishly in response to conditions facing all firms, especially in the presence of Knightian uncertainty, and so produce aggregate nominal wage stickiness. Consequently, New Keynesian ideas are often borrowed to explain nominal wage rigidity. [5]

For example, when continuity of association is broken, workers incur search and transition costs. On the other hand, firms lose non-transferable firm-specific skills and incur the costs of selecting and monitoring the performance of new workers. [6]

The idea of menu costs was developed with respect to setting prices, and is most often associated with Ball and Mankiw (1992a, 1992b). The principles of menu costs have since been applied to wage setting (see, for example, Kahn (1997)). [7]

To the extent that there has been analysis of wage flexibility in Australia, it has focussed on aggregate real wage flexibility (see, for example, Keating (1983)) or relative wages (see Fahrer and Pease (1994)). [8]