Industrial Output Variability and Real Wage Fluctuations: Determinants and Implications

I. INTRODUCTION The study of business cycles has been at the heart of macroeconomic theory for decades. Theoretical efforts have focused on providing an adequate explanation for sources of economic fluctuations, and toward this explanation, new Keynesian models have emphasized rigidity that interferes with market forces and exacerbates the effects of demand fluctuations on the supply side of the economy. The form of rigidity is in sharp contrast between sticky-wage and sticky-price models. Sticky-wage models have emphasized rigidity in the labor market to explain economic fluctuations. Labor contracts specify in advance the nominal wage that prevails for the contract duration. Following contract negotiation, a positive disturbance to aggregate demand raises the price of the output produced. In the absence of any stipulation for wage indexation, the increase in price lowers the real product wage faced by firms, causing it to fall below its market-clearing value. The fall in the real wage causes output and employment to rise above their natural, full-equilibrium levels. Output adjustments moderate the increase in price that is necessary to clear the product market. In addition, sticky-price models have emphasized rigidity in the product market to explain economic fluctuations. Monopolistically competitive firms face small "menu costs" when they change prices. Menu costs are resources involved in announcing and implementing a price change. Firms may opt, therefore, to change prices at specific intervals. Given price rigidity, producers adjust output in the face of demand shocks. Accordingly, an increase in the real wage correlates with an increase in output in the face of demand shocks. To test competing theoretical explanations, efforts have focused on the cyclical behavior of the real wage and accompanying output fluctuations in the face of demand shocks.1 The evidence appears conflicting and, therefore, does not convincingly support a given explanation.(2) Unlike previous empirical research on the subject, the objective of this investigation is to study the cyclical behavior of the real wage and the relative response of the nominal wage and price to demand shocks. Toward this objective, the present investigation estimates the time-series response of real wage rates to aggregate demand shocks in each of 28 private industries of the United States, (listed in Appendix Table A1). Differences in the response across industries are then used to discriminate between sticky-wage and sticky-price explanations. The evidence establishes the relation between output fluctuations and the response of the real wage to demand shocks across industries. The results across industries of the United States produce the following evidence. Contrary to the implications of sticky-wage models, the price response to demand shocks does not move closely with the nominal wage response. Consistent with the implications of sticky-wage models, however, an increase in nominal wage flexibility (rigidity) moderates (exacerbates) industrial output fluctuations in the face of demand shocks. Nonetheless, an increase (decrease) in price flexibility relative to nominal wage flexibility moderates (increases) the output response to demand shocks across industries. Consistently, industrial output fluctuations increase with the cyclical response of the real wage to demand shocks. For example, an increase in the real wage correlates with an increase in real output during periods of expansionary demand. In general, industrial prices adjust independently of the nominal wage to demand shocks, increasing real wage variability. Further, industrial real output variability does not vary significantly with nominal wage flexibility in the face of demand shocks. In contrast, an increase in the price response to demand shocks moderates output variability across industries. Consistently, an increase in the real wage response to demand shocks correlates with an increase in industrial real output variability, as predicted by sticky-price models of business cycles. …