What Is Wage Stickiness?
Wage stickiness, a core concept in macroeconomics, describes the phenomenon where nominal wages in a labor market are slow to adjust in response to changes in economic conditions. Unlike perfectly flexible markets where supply and demand might lead to immediate wage decreases during an economic downturn, wage stickiness suggests that wages, particularly nominal wages, resist falling. This resistance means that instead of wages declining, other adjustments, such as increased unemployment, may occur as businesses seek to manage costs.
History and Origin
The concept of wage stickiness, also known as nominal wage rigidity, is prominently associated with the work of John Maynard Keynes, particularly in his seminal work, "The General Theory of Employment, Interest, and Money." Keynes argued that during a recession, wages would not readily fall to restore full employment, a challenge to classical economic views. This observation was crucial to his theory, which posited that inadequate aggregate demand could lead to prolonged periods of high unemployment.24, During the Great Depression of the 1930s, widespread unemployment persisted despite significant economic contraction, providing empirical observations that aligned with the theory of sticky wages.23 Yale University economist Truman Bewley's 1999 book, Why Wages Don't Fall During a Recession, based on hundreds of interviews with business insiders, concluded that a primary reason for downward wage rigidity is that pay cuts severely damage employee morale, even more than layoffs.22
Key Takeaways
- Wage stickiness refers to the slow adjustment of nominal wages, particularly downwards, in response to changing economic conditions.
- This rigidity can contribute to higher unemployment rates during economic downturns, as firms may opt for layoffs over wage reductions.
- Factors contributing to wage stickiness include long-term contracts, social norms, union agreements, and efficiency wage theories.
- The phenomenon has significant implications for the effectiveness of monetary policy and fiscal policy.
- While inflation can erode real wages, nominal wages often resist outright cuts, making economic adjustments slower.
Interpreting Wage Stickiness
Interpreting wage stickiness involves understanding its implications for economic adjustment. When wages are sticky, especially "sticky-down" (meaning they are much more resistant to falling than rising), the labor market cannot quickly reach a new equilibrium during an economic shock. Instead of workers accepting lower pay in a downturn, firms might reduce their workforce, leading to involuntary unemployment.21 This rigidity can prolong periods of economic contraction and slow the recovery from a recession. The degree of wage stickiness can vary across sectors, with industries having strong unions or regulated wage standards often experiencing higher rigidity.20
Hypothetical Example
Consider a hypothetical country, Econland, experiencing an unexpected economic downturn leading to a sharp decrease in aggregate demand. In a perfectly flexible wage environment, businesses might immediately reduce nominal wages across the board to lower costs and maintain employment levels. However, in Econland, due to established employment contracts and social norms, wages prove sticky. Instead of cutting wages by, say, 10%, companies are reluctant to do so for fear of damaging employee morale and productivity. As a result, many businesses choose to lay off 10% of their workforce to achieve the necessary cost reductions. This leads to a rise in unemployment rather than a widespread decrease in pay for those who remain employed. Over time, persistent low inflation or even deflation could gradually erode the purchasing power of the unchanged nominal wages, effectively leading to a reduction in real wages, but the nominal wage itself remains resistant to direct cuts.
Practical Applications
Wage stickiness has significant implications for policymakers and economic analysis, particularly in the realm of monetary policy. Central banks consider wage dynamics when setting interest rates, as sticky wages can impede the economy's self-correction mechanisms.19 For instance, if wages are sticky downwards, a central bank's efforts to stimulate the economy through lower interest rates might be less effective in quickly reducing unemployment.18,17 Research by the Federal Reserve Bank of San Francisco indicates that wage changes do not follow a normal distribution, with many workers experiencing modest wage increases, few experiencing declines, and a substantial number experiencing no change at all, especially during economic downturns.16 This empirical evidence underscores the practical relevance of wage stickiness in understanding labor market responses to economic shocks.15
Limitations and Criticisms
While widely accepted in macroeconomics, the theory of wage stickiness faces some limitations and criticisms. Some economists argue that while nominal wages may appear rigid, real wages can still adjust through changes in the inflation rate. If inflation is positive, even a constant nominal wage results in a decline in real purchasing power, effectively reducing the labor cost for firms without an explicit wage cut.14 Furthermore, the degree of stickiness can vary, and in some economic models, wage rigidity is an outcome rather than an exogenous market failure.13 Critics also point out the difficulty in precisely measuring how sticky wages truly are, as it is challenging to determine what the "correct" or equilibrium wage should be at any given moment.12
Wage Stickiness vs. Price Stickiness
Wage stickiness and price stickiness are related but distinct concepts, both falling under the broader term of nominal rigidity.
- Wage Stickiness: Refers to the resistance of nominal wages to adjust quickly, particularly downwards, in response to changes in the labor market conditions or aggregate demand.11 This can result from factors like long-term contracts, employee morale concerns, or minimum wage laws.
- Price Stickiness: Describes the resistance of the prices of goods and services to adjust quickly to changes in aggregate supply or aggregate demand.10 This can be due to "menu costs" (the costs associated with changing prices, such as reprinting menus or updating systems) or strategic considerations by firms.9
Both phenomena contribute to the short-run non-neutrality of money and are central to New Keynesian economic models, explaining why markets may not always self-correct to full employment equilibrium.8 If both wages and prices are sticky, economic adjustments to shocks are amplified, potentially leading to prolonged periods of unemployment or output gaps.7,6
FAQs
Why are wages sticky?
Wages are sticky for several reasons, including long-term labor contracts that fix nominal wages for a set period, social norms that make employees resistant to pay cuts (even during economic downturns), the role of labor unions in collective bargaining, and "efficiency wage" theories which suggest that higher wages can boost worker morale and productivity.5,4
How does wage stickiness affect unemployment?
Wage stickiness can increase unemployment during economic downturns. When aggregate demand falls, businesses face reduced revenue. If they cannot easily lower wages to cut costs, they may resort to laying off workers instead, leading to higher levels of joblessness.3
Is wage stickiness always a negative phenomenon?
While often associated with negative outcomes like increased unemployment during recessions, some argue that wage stickiness can provide a degree of stability for workers' incomes, fostering consumer confidence and potentially smoothing consumption. However, its primary macroeconomic implication often relates to slower adjustments in the labor market in response to shocks.
How does inflation relate to wage stickiness?
Inflation can alleviate the impact of downward wage stickiness. If nominal wages remain constant while prices are rising, the real wages (purchasing power) of workers effectively decrease. This "real wage erosion" can help firms reduce labor costs without explicitly cutting nominal pay, facilitating market adjustment, especially when economic activity slows.2
What is the Phillips Curve's connection to wage stickiness?
The Phillips Curve illustrates an inverse relationship between unemployment and inflation. Wage stickiness is a key underlying assumption for the short-run Phillips Curve. If wages are sticky, a decrease in aggregate demand leads to higher unemployment rather than just falling wages and prices, thus demonstrating a trade-off that monetary policy might exploit in the short term.1