Scott Sumner  

How would we know if wages were sticky?

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I've done a lot of posts on wage stickiness, but misconceptions keep popping up. The sticky wage theory of the business cycle is based on the notion that only a fraction of wages get adjusted each period. This leads to some odd results. The bigger the fall in the equilibrium wage rate, the bigger the fall in the actual wage. That's no big surprise.

But what does seem to surprise people is that the bigger the fall in the equilibrium wage, the more that actual wages exceed equilibrium wages. That means that, according to the sticky wage theory, during periods where wages fall most the rapidly, we should expect to see the highest rates of unemployment. The same is true regarding cross sectional data.

Thus suppose that Nevada was hit by a severe real estate collapse, and its equilibrium wage fell by 10%. Also suppose that at the same time Texas was buoyed by an oil boom and its equilibrium wage rose by 4%. Finally, assume that due to sticky wages, the actual wage only moves by 1/2 of the amount that the equilibrium wage moves, in a given period. In this example, Nevada's actual wages would fall by 5% and therefore end up 5% above equilibrium, leading to mass unemployment. Texas wages would rise by 2% and end up 2% below equilibrium, leading to a tight labor market.

Now consider this example, when reading the following comment by Arnold Kling, who is discussing some research by Erik Hurst:

He says,
The facts are real wages moved very strongly with employment across regions. Nevada was hit very hard by the recession, for example, while Texas was hit much less hard. Wage growth, both nominal and real, was about 5 percent higher in Texas than it was in Nevada during the Great Recession.
Pointer from Tyler Cowen.

The point is that we do not have a single aggregate economy. If you think that every state faced identical demand conditions, then the state with the higher real wage growth (Texas) should have had the worse unemployment. And Hurst goes on to point out how the regional data make it difficult to defend the view that wage stickiness is the cause of unemployment.


Actually, that's exactly what you'd expect if sticky wages caused business cycles. And for similar reasons, interest rates tend to be at their lowest when they are the furthest above the Wicksellian equilibrium interest rate.


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COMMENTS (10 to date)
Thomas Hutcheson writes:

Shouldn't we be talking about sticky wages and prices? Why single out the labor market? If sticky wages were the only problem, would we not see output declines during recessions concentrated in the most labor intensive sectors?

baconbacon writes:

The Fed increases the inflation target, real wages fall in Utah, so they approach equilibrium, but real wages also fall in Texas so they move farther away from equilibrium. Net result is that efforts to relieve sticky wages in one area will cause problems in another, rendering the fed important (or limited potency depending on the size of the regions, etc).

Scott Sumner writes:

Thomas, Sticky wages explain the cause of recessions, but not how they vary by industry. Whatever causes recessions (sticky wages or otherwise) you'd expect output of investment goods to fall more sharply than output of consumption goods, for standard consumption smoothing reasons.

Bacon, You'd like to cause as little disruption as possible, which means a policy that leads to the overall level of wages being as close to equilibrium as possible. But the one size fits all problem suggests that no single policy can be perfect for all regions.

Michael Byrnes writes:

Is there a counterfactual here? If sticky wages were a non-issue, what would we have seen?

Brian Donohue writes:

Scott and bacon,

Aren't sticky wages asymmetrical, much more sticky downwards than upwards?

So, in Texas, actual wages will adjust to the equilibrium more easily than in Nevada.

Philip George writes:

For a "classical" proof that Keynes was right about flexible wages and unemployment, see Why is there involuntary unemployment?

James writes:

Wage stickiness is not a cause of business cycles by itself. If the marginal product of labor were stable and predictable, employers would hire people at wages close to their marginal product. Under such a scenario, wages could be sticky without leading to labor market disequilibrium.

It's worth asking: Why do employers have such a hard time predicting the marginal product of their potential hires?

baconbacon writes:
You'd like to cause as little disruption as possible, which means a policy that leads to the overall level of wages being as close to equilibrium as possible. But the one size fits all problem suggests that no single policy can be perfect for all regions.

And here it is. You cannot both hold this position and assert that the Fed can maintain a NGDP path in perpetuity. Support for employment in one area comes at a cost in another area, but worse than that is that support in a falling area comes at the cost of employment in a dynamic area (according to the sticky wages model above).

baconbacon writes:
Aren't sticky wages asymmetrical, much more sticky downwards than upwards?

So, in Texas, actual wages will adjust to the equilibrium more easily than in Nevada.

It is irrelevant. The sticky wages story is that the majority of UE in a recession is due to a coordination error that the Fed can smooth over. Maintaining trend inflation or ngdp (or national wages or whatever) will come at the cost of growth, and the "free lunch" of solving the coordination problem goes the way of "fiscal stimulus", where the lack of growth is perpetually claimed to be due to inadequate measures.

Rajat writes:

Scott, I get all of that except the last bit:

And for similar reasons, interest rates tend to be at their lowest when they are the furthest above the Wicksellian equilibrium interest rate.

How does the recovery happen then?

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