CYCLICAL COMOVEMENTS IN INDUSTRIAL LABOR AND PRODUCT MARKETS: THEORY AND EVIDENCE

I. INTRODUCTION Cyclical fluctuations among economic variables are at the heart of the study of business cycles. The explanations for the real and inflationary effects of business cycles can be classified into equilibrium and new Keynesian alternatives. The equilibrium explanation of business cycles pioneered by Lucas [1973] relies on imperfect information about sources of demand shifts that provide an explanation for the output-inflation tradeoff in the face of aggregate demand shifts. In contrast, the common theme of the new Keynesian explanation of business cycles concerns nominal rigidity that interferes with market forces in determining the allocation of cyclical shifts among nominal and real magnitudes. The form of rigidity varies between sticky-price and sticky-wage new Keynesian explanations. The former (see, e.g., Ball, Mankiw and Romer [1988]) advocates the presence of "menu costs" that determine the frequency of price adjustment and, in turn, the output-inflation tradeoff. In contrast, contractual wage rigidity (see, e.g., Gray [1978]) advocates the presence of implicit or explicit agreements that determine the frequency of wage and salary negotiations across the economy. Wage flexibility determines, in turn, the output-inflation tradeoff during business cycles. The detailed treatment of cyclical conditions in the labor market is among the primary differences between the contractual wage-rigidity explanation and contending explanations of business cycles. Conditions in the labor market determine cyclical fluctuations in wages and labor employment. The resulting tradeoff between wage inflation and unemployment is crucial in determining the price and quantity effects of cyclical fluctuations. In contrast, conditions in the labor market are not crucial to competing explanations of business cycles. In the context of the Lucas imperfect-information model, agents are assumed to be self-employed for simplicity. This eliminates the need for an explicit treatment of the cyclical fluctuations of wages. In the context of the sticky-price new Keynesian models, wages may vary according to conditions in a Walrasian labor market or in the form of "installment payments" that do not fluctuate with the cycle. Accordingly, conditions in the labor market do not explain the output-inflation tradeoff during business cycles. Because business cycles are inherently complex economic phenomena, theories tend to be highly controversial. This in turn, has stimulated the interest of macroeconometric researchers to establish the empirical validity of business-cycle theories.(1) Efforts have focused on testable hypotheses that establish the empirical validity of the alternative explanations. In this investigation, we seek to contribute to these efforts. More specifically, the analysis of the paper will seek to evaluate the validity of the unique implications of the sticky-wage explanation of business cycles concerning correlations between labor-market conditions and the output-inflation tradeoff. Towards this objective, we investigate a sample of 28 private U.S. industries. First, we use time-series data to estimate the cyclical responses of output, inflation, nominal and real wages to demand and supply shocks impinging on the stochastic structure of each industry. The nominal and real wage responses to the various shocks will serve as a measure of the degree of wage flexibility. Further, according to the contractual wage-rigidity theory, wage rigidity can be influenced by the duration of wage contracts as well as the presence of wage indexation. Without wage indexation, longer contracts are associated with a larger cyclical response of the real wage to demand and supply shocks. Thus, the labor market is hypothesized to be a primary source that influences the output-inflation tradeoff across industries. Secondly, we use our time-series estimates indicating the cyclical response of wages, output and prices to various shocks as a source of data enabling us to provide a comprehensive cross-sectional evaluation of the contractual wage-rigidity hypothesis. …