Media Briefings

Low Inflation Increases Wage Flexibility And Boosts Employment: Evidence From Germany

  • Published Date: November 2007


Lower inflation has led to greater wage flexibility, increased employment and
improved overall economic performance, according to new research by Professor
Uwe Sunde and colleagues, published in the November 2007 issue of The
Economic Journal
. The study shows that wage rigidity in Germany declined
substantially after the end of the high inflation period of the 1970s.
In the late 1970s, only about one fifth of all wage changes in Germany were
conducted in a fully flexible manner. The researchers estimate that this led to wages
increasing between 1% and 2% more each year than they would have done if wages
had been completely flexible. This led to higher unemployment in Germany over
this period.
Wages became more flexible subsequently, with around a half of wages being set
flexibly in the 1990s. The researchers argue that this was driven by the reduction in
inflation. As inflation fell from its 1970s highs, workers did not demand that their
wages kept pace with inflation to the same extent (so-called ‘real’ wage rigidity). This
allowed real wages to fall when needed, which improved economic performance.
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 either nominal or real wage rigidity exists, then wages cannot easily be adjusted
downwards. This means that unemployment will increase more than it otherwise
would during a downturn.
Using data from individual wage records from West Germany over the period 1975 to
2001, the researchers find evidence for substantial downward wage rigidities. But the
results show that the extent of overall wage rigidity has declined substantially, with
about half of all wage changes being unaffected by rigidities in the 1990s.
The pattern of wage rigidity changed dramatically with the inflation environment.
Real wage rigidity was widespread in times of high inflation as in the late 1970s. In
an environment of low inflation, as in the 1990s, wages were more likely to exhibit
nominal wage rigidity. This pattern is consistent with individuals ignoring inflation
once it becomes sufficiently low.
Possible other explanations for the observed pattern include declining union power
and increasing importance of decentralised wage setting. Additional evidence shows
that excessive wage growth due to rigidities tends to increase future unemployment.
Overall, these results indicate that prudent monetary policy controlling inflation at
moderate levels might help to minimise the extent of rigidities preventing nominal
and real wage adjustments and their adverse labour market effects.
ENDS
Notes for editors: ‘Real and Nominal Wage Rigidities and the Rate of Inflation:
Evidence from West German Micro Data’ by Thomas Bauer, Holger Bonin, Lorenz
Goette and Uwe Sunde is published in the November 2007 issue of The Economic
Journal.

Thomas Bauer is at the University of Bochum. Lorenz Goette is at the Federal
Reserve Bank of Boston. Uwe Sunde is at the Universität St Gallen in Switzerland.
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); Holger Bonin by email (bonin@zew.de); or
Romesh Vaitilingam on 07768 661095 (email: romesh@compuserve.com).