NBER WORKING PAPER SERIES EVALUATING THE ECONOMIC SIGNIFICANCE OF DOWNWARD NOMINAL WAGE RIGIDITY

The existence of downward nominal wage rigidity has been abundantly documented, but what are its economic implications? This paper demonstrates that, even when wages are allocative, downward wage rigidity can be consistent with weak macroeconomic effects. Firms have an incentive to compress wage increases as well as wage cuts when downward wage rigidity binds. By neglecting compression of wage increases, previous literature may have overstated the costs of downward wage rigidity to firms. Using microdata from the US and Great Britain, I find that evidence for compression of wage increases when downward wage rigidity binds. Accounting for this reduces the estimated increase in aggregate wage growth due to wage rigidity to be much closer to zero. These results suggest that downward wage rigidity may not provide a strong argument against the targeting of low inflation rates. Michael W. Elsby University of Edinburgh School of Economics 31 Buccleuch Place Edinburgh EH8 9JT United Kingdom Mike.Elsby@ed.ac. uk A longstanding issue in macroeconomics has been the possible long run disemployment e¤ects of low ination. The argument can be traced back to Tobin (1972): If workers are reluctant to accept reductions in their nominal wages, a certain amount of ination may grease the wheelsof the labor market by easing reductions in real labor costs that would otherwise be prevented. This concern has resurfaced with renewed vigor among economists and policymakers in recent years as ination has declined and evidence for downward rigidity in nominal wages has accumulated. A stylized fact of recent micro-data on wages is the scarcity of nominal wage cuts relative to nominal wage increases (Lebow, Stockton, & Wascher, 1995; Kahn, 1997; Card & Hyslop, 1997). This evidence dovetails with surveys of wage-setters and negotiators who report that they are reluctant to cut workerswages (see Howitt, 2002, for a survey). In an inuential study, Bewley (1999) nds that a key reason for this reluctance is the belief that nominal wage cuts damage worker morale, and that morale is a key determinant of worker productivity.1 Exploring the macroeconomic implications of downward nominal wage rigidity from both a theoretical and an empirical perspective, I nd that these e¤ects are likely to be small. Section 1 begins by formulating an explicit model of worker resistance to nominal wage cuts.2 Based on Bewleys results, the model makes the simple assumption that wage rigidity arises because the productivity of workers declines sharply following nominal wage cuts.3 Wage rigidity, according to Bewleys evidence, is therefore allocative in the sense of Barro (1977), because it a¤ects the productivity of workers. This simple assumption implies a key insight that has not been recognized in the literature that nominal wage increases in this environment become irreversible to some degree. A rm that raises the wage today, but reverses its decision by cutting the wage by an equal amount tomorrow will experience a reduction in productivity: Todays wage increase will raise productivity, but tomorrows wage cut will reduce productivity by a greater amount.4 1While Bewleys explanation has been inuential, it is not the only possible explanation. Other studies have suggested that the tendency for past nominal wages to act as the default outcome in wage negotiations can lead to downward wage rigidity (MacLeod & Malcomson, 1993; Holden, 1994). 2Given the empirical evidence for worker resistance to wage cuts, it is surprising that there has not yet been an explicit model of such wage rigidity in the literature. The need for such a model has been noted by Sha r, Diamond & Tversky (1997, p.371): Plausibly, the relationship [between wages and e¤ort] is not continuous: there is a discontinuity coming from nominal wage cuts. A central issue is how to model such a discontinuity. This sentiment is echoed more recently by Altonji & Devereux (2000, p.423 note 7) who write: [I]t is surprising to us that there is no rigorous treatment in the literature of how forward looking rms should set wages when it is costly to cut nominal wages.  3Bewley also suggests that wage rigidity is enhanced by rmsinability to discriminate pay across workers within a rm. For simplicity, I abstract from this possibility. For models that incorporate this feature, but abstract from downward nominal wage rigidity, see Thomas (2005), and Snell & Thomas (2007). 4In this sense, the model is formally similar to asymmetric adjustment cost models, such as the investment model of Abel & Eberly (1996) and the labor demand model of Bentolila & Bertola (1990).