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

02 Nov 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.

''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

University of Bochum | thomas.bauer@rub.de

Uwe Sunde

University of St. Gallen

Uwe.Sunde@econ.lmu.de

Lorenz Goette

University of Lausanne | +41-21-692-3496 ( | lorenz.goette@unil.ch