Media Briefings

Low And Stable Inflation Eases Labour Market Adjustment In A Downturn

  • Published Date: November 2007


Low and stable inflation is crucial in allowing the labour market and hence the wider
economy to adjust in the face of a downturn. That is one of the conclusions of a
series of studies published in the November 2007 issue of The Economic Journal.
The research looks at evidence on the causes and consequences of downward
wage rigidity (where workers resist pay cuts) in three major European countries –
Britain, Germany and Italy. They suggest that an environment of moderate inflation
may help to obtain wage outcomes that are favourable for economic performance by
minimising the adverse effects of wage rigidities.
The rate of inflation serves as benchmark for most wage negotiations. In addition,
the link between inflation and wages is one of the most important channels through
which inflation affects the wider economy.
Wage flexibility is crucial in allowing the economy to adjust to shocks and the
business cycle. If workers resist a cut in their money wage in response to a downturn
(‘nominal wage rigidity’), then this can result in unemployment.
Inflation can lower the real value of a fixed nominal wage (as the same wage will buy
fewer goods and services), so real wage adjustment can take place even if nominal
wages do not fall.
But in the presence of high inflation, workers may be aware of rising prices and be
less willing to accept wage increases below the level of inflation. This is known as
‘real wage rigidity’.
If there is either nominal or real wage rigidity, then wages cannot easily be adjusted
downwards. This means that unemployment will increase more than it otherwise
would during a downturn.
ENDS
Notes for editors: ‘Wage Rigidity: Measurement, Causes and Consequences’ by
Lorenz Goette, Uwe Sunde and Thomas Bauer is published in the November 2007
issue of The Economic Journal.
Lorenz Goette is at the Federal Reserve Bank of Boston. Uwe Sunde is at the
Universität St Gallen in Switzerland. Thomas Bauer is at the University of Bochum.
For further information: contact Uwe Sunde on +41 71 224 23 09 (email:
uwe.sunde@unisg.ch); Lorenz Goette by email (lorenz.goette@bos.frb.org); Thomas
Bauer by email (thomas.bauer@rub.de); or Romesh Vaitilingam on 07768-661095
(email: romesh@compuserve.com).