Steinar Holden1 Wage formation under low inflation EMU entails ambitious target for price stability, which gives limited scope for nominal wage –In particular for a country that wants to reduce wage cost level as compared to neighbours If inflation so low that downward nominal wage rigidity DNWR binds, what is the effect on unemployment? –Even if sufficient room for wage growth in normal times, may be different in recessions

Steinar Holden2 Sources of DNWR Fairness –Survey evidence: nominal wage cuts viewed as unfair even when same real wage cut would be viewed as fair if due to price increase (Shafir et al 1997, Bewley, 1999) –Experimental evidence Fehr and Tyran (AER, 2001) Legal restrictions –Nominal contracts can only be changed by mutual consent (MacLeod Malcomson, 1993, Holden, 1994). –Firms must “force” workers/unions to accept wage cut by threats of layoffs, lock-out, closing down plant, etc

Steinar Holden3 Effect of nominal wage contract on wage negotiations – an illustration Assume wage outcome after strike or lock-out = 100 Assume costs of strike or lock-out = 5 Old contract wage = 90 (inflation reduced real value) Threat of strike is credible, as this gives higher payoff to the workers (100 – 5 = 95) than the initial wage of 90 But firm can offer 95 + ε, which gives higher payoff to workers than a strike does => workers will accept Bargaining outcome is 95 + ε, and no strike takes place

Steinar Holden4 Strategic effect of inflation cont. Old contract wage = 110 –negative inflation or negative shock implies that wage must go down Threat of lock-out is credible, as this gives higher payoff to firm ( = 105) than initial wage does But workers can offer ε, which gives higher payoff for firm than a lock-out does => firm will accept Bargaining outcome is ε, and no lock-out takes place Bargaining outcome depends on initial wage: High inflation erodes real value of old contract => leads to lower real wage outcome

Effect of DNWR on wage changes Steinar Holden5

Effect of DNWR on wage changes Steinar Holden6

Holden og Wulfsberg (2009) Steinar Holden7

8 The standard model with no DNWR Real wage Employment N Wage curve N* Price curve Steady-state inflation has no effect on eq. employment

Steinar Holden9 DNWR and low steady-state inflation Real wage Employment N Wage curve, no inflation Wage curve, high inflation N L N H Price curve

Steinar Holden10 The long run Phillips-curve Inflation Unemployment U L U H

Steinar Holden11 Simulation of long-run Phillips-curve (Holden, Economica, 2004) Firm-specific shocks causes changes in relative wages Two percent annual growth in labour productivity Two percent increase in nominal wages in organised sector unless firms threaten to use lock-out (due to work-to-rule or go-slow threats by workers) Stronger DNWR in Europe due to higher bargaining coverage and stricter EPL

However: DNWR attenuates wage rises at low inflation Steinar Holden12 Employers know that DNWR makes it difficult to cut wages in the future (Elsby, JME 2009) Will lower wage increases so as to reduce risk that DNWR binds in the future Makes inflation more stable when low Reduces risk that e.g. oil price shocks feed into wage increases Blanchard & Riggi (2009): less wage indexation and more credible monetary policy

Steinar Holden13 Will labour markets and wage setting institutions adapt to low inflation? Under low inflation, nominal wage cuts will be frequent, and no longer viewed as unfair (Mankiw 1996, Gordon,1996) But: fairness and legal restrictions are complementary DNWR prevent frequent wage cuts, thus no erosion of fairness argument fairness argument prevents change of legal restriction downward wage rigidity closely connected to employment protection

Steinar Holden14 Evidence of adaption to low inflation Switzerland early 1990s: persistent DNWR in spite of low inflation and high and increasing unemployment (Fehr and Goette, 2005) Sweden early 1990s: persistent DNWR in spite of high and increasing unemployment (Agell and Lundborg, 2003).

Steinar Holden15 Concluding remarks Rigorous theoretical explanations for downward nominal wage rigidity (DNWR) (fairness and legal restrictions) –Strong empirical evidence that downward nominal wage rigidity prevails in many countries –Evidence that wage setting adapts, yet DNWR is persistent even under high unemployment Not clear at what rate of inflation DNWR will bite –productivity growth provides room for nominal wage growth –changes in relative wages requires aggregate wage growth DNWR may also stabilise wage and price growth under low/moderate inflation