Nominal wage rigidity

What Is Nominal Wage Rigidity?

Nominal wage rigidity refers to the phenomenon in which nominal wages—the actual amount of money paid to employees—are resistant to downward adjustments, even in the face of changing economic conditions such as a recession or declining labor demand. This concept is a core element within macroeconomics and labor market analysis, particularly in New Keynesian economics where it helps explain why markets may not clear quickly. When nominal wages are rigid, they do not fall proportionally to decreases in price levels or productivity, which can lead to higher unemployment as employers face higher real labor costs.

History and Origin

The concept of nominal wage rigidity has deep roots in economic thought, notably gaining prominence with John Maynard Keynes's work, The General Theory of Employment, Interest, and Money (1936). Keynes argued that nominal wages display a downward rigidity, meaning workers are reluctant to accept cuts in their money wages. This reluctance, he suggested, could lead to involuntary unemployment because it hinders the labor market from reaching a new economic equilibrium during economic downturns, a situation he believed applied to the Great Depression.

Modern economic models, particularly within the New Keynesian economics framework, often incorporate nominal wage rigidity alongside sticky prices to explain how monetary shocks can have real effects on the economy. Research suggests that workers' perceptions of fairness play a significant role in this phenomenon, as nominal wage cuts are often viewed as unfair, potentially leading to decreased effort or morale.

##¹⁸ Key Takeaways

• Nominal wage rigidity describes the resistance of money wages to decrease, even when economic conditions would suggest such a decline.
• It is a key feature in New Keynesian economic models, explaining why monetary policy can affect real economic variables.
• The phenomenon can contribute to higher unemployment during recessions or periods of low inflation, as firms may find it difficult to reduce real labor costs without layoffs.
• Behavioral factors, such as workers' aversion to nominal wage cuts, are considered a primary cause of this rigidity.

Interpreting Nominal Wage Rigidity

Interpreting nominal wage rigidity involves understanding its implications for how economies adjust to shocks. When nominal wages are rigid, especially downwards, the labor market cannot easily facilitate adjustments in real labor costs through nominal wage reductions. Instead, firms facing reduced aggregate demand or productivity shocks may resort to other measures, such as layoffs or reduced hiring, leading to increased unemployment. This contrasts with a hypothetical perfectly flexible wage environment, where wages would adjust instantly to maintain full employment. The degree of nominal wage rigidity influences the severity and duration of economic downturns, particularly in low-inflation environments where nominal wage cuts would otherwise be necessary for real wage adjustment.

Hypothetical Example

Consider a hypothetical manufacturing company, "Widgets Inc.," during a period of economic slowdown and decreasing aggregate demand. The company's sales and revenue are declining, and to remain profitable, it needs to reduce its labor costs. If nominal wages were perfectly flexible, Widgets Inc. might be able to reduce its employees' hourly wages by, say, 5% across the board. However, due to nominal wage rigidity, workers are resistant to these nominal wage cuts. Employees might view a 5% nominal wage cut as unfair or a significant loss in their take-home pay, even if the cost of living (and thus inflation) is also falling or stagnant.

Facing this rigidity, Widgets Inc. finds it difficult to implement wage reductions without risking employee morale, productivity, or even strikes. Instead, to cut costs, the company may opt for layoffs, reducing its workforce by 10%. This scenario illustrates how nominal wage rigidity can lead to higher unemployment during a downturn, as firms choose to reduce the number of employees rather than reduce the nominal wages of their existing workforce.

Practical Applications

Nominal wage rigidity has significant practical implications across various facets of the economy, particularly for monetary policy and business cycles.

• Monetary Policy: Central banks, such as the Federal Reserve, consider nominal wage rigidity when formulating monetary policy. In an economy with sticky nominal wages, monetary policy interventions, like interest rate adjustments, can have a greater impact on real economic activity (like output and employment) because prices and wages don't adjust immediately to offset the policy. Thi¹⁷s non-neutrality of money is a cornerstone of New Keynesian economic models.
• Unemployment: During periods of low inflation or deflation, downward nominal wage rigidity can exacerbate unemployment. If firms cannot cut nominal wages, and real wages become too high relative to productivity or prices, firms may reduce employment rather than lower pay.
• ¹⁶ Business Cycles: Nominal wage rigidity contributes to the asymmetric nature of business cycles. Negative shocks to aggregate demand can lead to larger employment contractions because wages are slow to adjust downwards, while positive shocks might see quicker wage increases.

##¹⁵ Limitations and Criticisms

While nominal wage rigidity is a widely accepted concept in macroeconomics, it is not without limitations and criticisms. One significant critique revolves around the "Lucas critique," which suggests that microeconomic behavior, including wage-setting, may change in response to a different macroeconomic environment. For instance, if a low-inflation environment persisted, the argument goes, workers' opposition to nominal wage cuts might erode over time, making nominal wages less rigid.

Fu¹⁴rthermore, the empirical evidence on the macroeconomic impact of nominal wage rigidity can be mixed. While micro-level data often show a strong resistance to nominal wage cuts, the extent to which this translates into significant aggregate macroeconomic effects, such as a major increase in average real wage growth that impedes optimal monetary policy, is debated. Som¹³e research indicates that while statistically significant, the macroeconomic impact of this distortion might be modest.

##¹² Nominal Wage Rigidity vs. Real Wage Rigidity

Nominal wage rigidity and real wage rigidity are distinct concepts in economics, though both describe the stickiness of wages and can impact the labor market and overall economy.

Nominal wage rigidity specifically refers to the resistance to a cut in the stated dollar amount of a wage. This means that if there's deflation or very low inflation, even if real wages increase because prices are falling faster than nominal wages, firms may still be hesitant to cut nominal wages. In contrast, real wage rigidity implies that the wage, once adjusted for inflation, resists downward movement. This often stems from factors like efficiency wage theory, where firms pay above-market wages to boost productivity, or collective bargaining agreements that maintain real wage levels. Both forms of rigidity can prevent the labor market from reaching its full potential, but they do so through different mechanisms and for different reasons.

FAQs

Why are nominal wages often rigid downwards?

Nominal wages are often rigid downwards due to a combination of behavioral and institutional factors. Workers tend to resist cuts in their money wages due to a psychological aversion to nominal losses, known as "money illusion," or a perception that nominal cuts are unfair. Add¹¹itionally, factors like long-term contracts, union agreements, and the administrative menu costs associated with renegotiating wages can contribute to this rigidity.

How does nominal wage rigidity affect the economy?

Nominal wage rigidity can prevent the labor market from adjusting smoothly to economic shocks, particularly negative ones. If nominal wages cannot fall, firms may reduce employment (layoffs) instead of wages during a recession or period of weak aggregate demand. This can lead to higher and more persistent unemployment and can amplify the severity of business cycles.

Is nominal wage rigidity more pronounced during low inflation?

Yes, nominal wage rigidity is generally considered to be more pronounced and have a greater impact during periods of low inflation or deflation. When inflation is high, a stable or even slightly increasing nominal wage can still translate into a real wage cut, allowing firms to effectively reduce labor costs without cutting the money amount. However, in low-inflation environments, firms needing to reduce real labor costs must cut nominal wages, directly confronting the rigidity.

##¹⁰# Does nominal wage rigidity always lead to unemployment?

Not necessarily. While nominal wage rigidity can contribute to unemployment, especially during economic downturns, its effect can be mitigated by other factors, such as positive aggregate supply shocks or successful monetary policy that stimulates demand. The extent to which it leads to unemployment depends on the severity of the rigidity and the overall economic environment.^123456789