Explain for which reasons the real wage is expected to be acyclical in the classical model, countercyclical in The Keynesian Model and Procyclical in the New Keynesian model. Which model better fits the empirical evidence? Introduction The concept of real wages has increasing significance in the current world. Rising inflation and recession in almost all major economies have led to the importance of studying real wage with respect to prices and economies themselves. Such a study would require an in-depth understanding of the business cycle of real wages.
From Classical theory to New Keynesian theory, Cyclicality of real wage has been defined in contrasting terms. Much of the conflicting evidence is simply characteristic of empirical research. Researchers use different model specifications and estimation techniques. Empirical results are often sensitive to the choice of cyclical indicators and time period chosen (Dimelis, 2007). This essay seeks to explain why real wage is expected to be acyclical in the classical model, counter-cyclical in the Keynesian model and procyclical in the New Keynesian model and shed light on which model best fits empirical evidence.
Real Wage Real wage is defined as the “wage paid to the average worker divided by the price level. ”(Delong and Olney,2006 p. 535) It therefore measures the cost of labour in real terms as it is the number of units of output that can be exchanged for one time-based unit of work. (Levacic and Rebmann, 1982) The Classical Model In the classical model, the basic assumption is that prices and wages are flexible. The basis of classical theory is that the markets work perfectly, that prices adjust rapidly to cover any gap that may arise due to a difference in the quantities demanded and supplied. Delong and Olney,2006) The classical model thus assumes full employment, i. e. the actual output matches the potential output of the economy. Since prices are flexible, an increase in the supply of labour will lead to a deficit in the demand, as a result some workers will become unemployed, and some of the unemployed will offer their labour at a lower wage in an attempt to secure employment. As a result, those employed will also lower their wages causing the wage to decline relative to price level P, and real wage to fall.
Due to the law of diminishing returns of marginal product of labour, as real wage falls, firms wishing to maximize their profit will employ more workers leading to an automatic adjustment of the labour market which is once again at equilibrium. In the case of demand exceeding supply, firms will offer higher wages to attract workers which will cause the real wage to rise. As a result other firms will reduce their labour such that the demand equals the supply again, and the labour market is at equilibrium.
Thus real wage, in the classical model ,its movement is independent of the direction of growth of economy and is thus said to be acyclical. (Delong and Olney,2006; Mankiw, 2003) Though few empirical studies support the theory that wages are acyclical, most critics pointed out that many wages and prices are not flexible and it is this inflexibility that explains both the existence of unemployment and the non-neutrality of money (Mankiw,2003) .
Gamber and Joutz(2001) in their paper ‘Real wages over the business cycle’ studied the movement of real wage with respect to labour supply,demand ,aggregate demand and oil prices and concluded that increases in oil prices and reduced hours had little impact on the real wage thus making real wage acyclical. This could be true of the data studied, however many researchers including Solon et al (1994) have questioned evidence that claimed real wage to be acyclical, saying that a compositional bias tends to mask the true cyclical behaviour of a particular group’s real wage.
The Keynesian Model While the classical model is only appropriate when wages and prices are flexible, it provides a simplified analysis of how the economy works. A more realistic model is however the Keynesian model which is very different from the classical model in many ways. To begin with, the model does not guarantee full employment and the actual output does not always equal potential output which is due to the basic assumption that prices and wages are “sticky”. That is, they will not move freely and rapidly in response to a change in demand or supply. (Delong and Olney, 2006)
The reasons behind sticky prices have been identified by many economists; some explanations given include the impact of implicit contracts which involve non variable wages together with a probability of layoff, without appealing to risk averse behaviour (Levacic and Rebmann, 1982). Another simplified explanation is that managers and workers find re negotiating wages costly or they lack sufficient information. The problem of “money illusion” is also a possible explanation where workers and managers overlook the effect of price level changes when assessing the impact of changes in wages or prices on their real income. Delong and Olney,2006) In the Keynesian model, if there is a decline in a consumer’s propensity to consume, there will be a fall in expenditure for goods. However, there is no change on the spending on investment goods, flow of exports or government expenditure. When firms see the spending on their products declining, they will reduce the production rather than prices since prices are sticky to avoid accumulating unsold inventory. When firms reduce their production, naturally they will fire some of the workers since workers will not reduce their wages (as they are sticky).
This leads to an overall drop in the national income, which as a result of the multiplier effect is greater than the decline in consumer spending. (Delong and Olney, 2006) Keynes’ theory assumes that there is a negative correlation between real wage and output or employment, i. e. that real wage in the Keynesian model is counter-cyclical (Blanchard and Fisher, 1989). Some empirical data supports this behaviour, Swanson(2007, p. 33), in his paper says that “anecdotal evidence from the Great Depression and the 1920–21 contraction strongly suggests that real wages were countercyclical during these episodes: e. . , “[Benjamin] Strong wanted to wait until wage rates were lower. He noted that deposits had fallen off considerably, retail prices had fallen moderately, wholesale prices precipitously [56%], but wages had hardly been affected (Friedman and Schwartz (1963) as cited in Swanson (2007), p. 33). ” Swanson (2007, p. 34)also notes that “workers’ wages have been counter cyclical over both the post-War and post-1967 period when those wages are deflated by the price index of the worker’s own 2-digit or 4-digit industry and compared to the state of economic activity in that same industry. And studies using data disaggregated by industry have shown a rather countercyclical behaviour for the US (Mehra, 1982; Burda, 1985 as cited in Dimelis, 1997 p. 312)) Although the Keynesian model was a more realistic model, it was criticised for its lack of clarity on how the labour market, and equilibrium is attained. This led to the development of New Keynesian Economics. (Mankiw, 2003) New Keynesian Model Partly due to criticism of Keynesian Economics, New Keynesian Economics was developed.
The new Keynesian model tries to explain how wages and prices behave in the short run by identifying the market imperfections that make them sticky and cause the economy to shift from its natural state. (Mankiw, 2003) In other words, it uses micro foundations to explain macroeconomic effects. The model, like the Keynesian model builds on the assumptions of sticky wages and prices with the traditional model of aggregate demand and supply and tries to provide a better explanation of why wages and prices are sticky in the first place.
It proposes that small costs of adjustment or rigidities can have large macroeconomic effects. (Mankiw, 2003). Blanchard and Gali (2005, p. 10)assume that “real wages respond sluggishly to labor market conditions, as a result of some (unmodelled) imperfection or friction in labor markets. ” It also assumes that real wages of the current period to some extent depend on the real wage of the previous period. And that current inflation is the result of decisions based on news about future demand and cost conditions obtained in previous periods, in addition to current information.
A consequence of that “distributed lag” property is the emergence of inertia in inflation. (Blanchard and Gali, 2005) Real wages are procyclical and are thus positively correlated with the output, they rise as output rises (above its natural level) and fall as output declines (relative to its natural level). This is because nominal wages are positively correlated with the business cycle, while prices in the New Keynesian model are sticky. (Mankiw, 2003) In the above explanation of the classical and Keynesian model, there is some empirical evidence that supports the behaviour real wage as acyclical and counter-cyclical.
However, there are a larger number of studies that conclude that real wage generally exhibits procyclical behaviour ( Keane, et al. (1988);Kydland and Prescott (1989);Solon et al. (1994);Peng and Siebert(2008)). According to Blanchard and Fisher(1989, p. 19), real wage is weakly procyclical, showing a positive correlation between real wage and output but being “statistically insignificant”. However, Solon et al. (1994) found the aggregate real wage to be significantly procyclical and in a further investigation found that micro study of the same data revealed stronger procyclicality of real wage than that revealed by aggregate data. Kandil and Woods, 2002) Several empirical studies of real wage cyclicality of various countries such as Germany(Dimelis, 1997), Italy(Peng and Siebert, 2008) and USA( Solon et al. , 1994; Kandil and Woods, 2002) conclude that real wage is more procyclical in nature. One can draw the conclusion that, real wage, as supported by empirical evidence, is procyclical, whether it is weakly procyclical or significantly so. Conclusion It can thus be concluded that, the three models explained differ in many aspects particularly their explanation of the behaviour of real wage.
Studies have been undertaken to understand the cyclicality of real wage with respect to real market conditions, and although some studies support that real wage is acyclical and counter-cyclical, a larger number of studies show that real wage is procyclical on an average. On a micro level as well, real wage has shown strong procyclicality. As mentioned before, the great variance of results in the study of real wage could be a result of the different techniques employed for research, the sample of data studied or if the study was aggregate based or disaggregate based.
Thus, while the Classical and Keynesian models are applicable in certain cases, the new Keynesian model is appropriate for many of the prevalent markets or economies. References Blanchard, O. J & Fisher, S, 1989, Lectures on Macroeconomics, MIT press Blanchard, O. J. and Gali, J. , Real Wage Rigidities and the New Keynesian Model (October 31, 2005). MIT Department of Economics Working Paper No. 05-28; FRB Boston Working Paper No. 05-14. Available at SSRN: http://ssrn. com/abstract=842285 Delong , J. B & Olney, M.
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