THE RELATIVE STICKINESS OF WAGES AND PRICES

I. INTRODUCTION A continuing challenge to macroeconomics is to explain how a purely nominal disturbance produces short-term aggregate real effects. In the classical paradigm, in which wages and prices are perfectly flexible, a positive nominal (aggregate demand) disturbance will cause nominal wages and output prices to rise in the same proportion, leaving real wages unchanged. Thus, neither employment nor output will be affected. Consequently, many business cycle theories posit the existence of wage and/or price stickiness to explain how (nominal) aggregate demand disturbances generate real macroeconomic effects. According to these theories, the failure of nominal wages or prices to fully adjust in the short run to purely nominal disturbances explains why shocks to aggregate demand will cause both employment and output to temporarily deviate from their natural rates. The relative importance of wage and price stickiness in the transmission of nominal shocks to the real economy, however, remains an unsettled issue. The purpose of this paper is to exploit evidence on the behavior of real wages in an attempt to assess the relative importance of these two sources of stickiness. First, consider models emphasizing sticky or slowly adjusting nominal wages.(1) If, for example, output prices are free to adjust but nominal wages are sticky, a positive aggregate demand shock will cause prices to rise and real wages to temporarily fall below market-clearing levels. The fall in real wages will stimulate employment (and, thus, output) as the aggregate demand shock induces movement along a stable labor demand curve. Consequently, sticky-wage models predict a negative correlation between aggregate demand shocks and real wages. If, on the other hand, wages are flexible while output prices are sticky,(2) aggregate demand disturbances and real wages will tend to be positively correlated in the short run. In sticky-price models, imperfectly competitive firms may resist adjusting output prices in response to changes in demand, perhaps due to "menu costs." Instead, increases in demand are met by corresponding increases in output. This requires an increase in labor inputs, which, in turn, requires an increase in the real wage rate if wages are flexible and the labor supply curve is positively sloped. Thus, when prices are sticky but wages are flexible, a positive aggregate demand shock is associated with an increase in real wages. It may be that neither prices nor wages are fully flexible. If prices and wages both exhibit stickiness we would expect real wages to be positively correlated or negatively correlated with aggregate demand shocks depending, in large part, on whether prices or wages are stickier. Thus, knowledge of the direction of the short-run response of real wages to aggregate demand disturbances would offer important evidence on the relative stickiness of nominal wages and output prices. If all business cycle fluctuations are due solely to aggregate demand disturbances, such evidence could be obtained by examining the cyclical behavior of real wages. Since, regardless of the source of stickiness, aggregate demand disturbances are positively correlated with employment and output, countercyclical (procyclical) real wages would indicate that nominal wages are stickier (more flexible) than output prices. Indeed, some consider the "stylized fact" of slightly procyclical real wages(3) to be an important challenge to models that emphasize wage stickiness. For example, Bennett McCallum [1986] argues for the superiority of models with sticky output prices since if "wage stickiness alone were responsible for the real effects of monetary actions, with product prices adjusting flexibly, then we should observe countercyclical movements in the real wage. That we do not has recently been reconfirmed in a study by Bils [1985]." Gregory Mankiw [1987, 107] has concluded: "The final, and perhaps most serious, problem with the unadorned nominal wage story is that real wages do not move over the business cycle as the theory predicts. …