Some Efficiency Effects of Inflation Under Nominal Wage Rigidity

Abstract:     
There is an extensive literature on the effects of downward nominal wage rigidity (DNWR) on employment, wage and macroeconomic outcomes going at least as far back as Keynes’ General Theory. This literature, however, focuses almost exclusively on ex post effects - namely, what are the employment and efficiency effects when the equilibrium wage falls but the actual wage paid does not or cannot fall to match it. This paper addresses the question in a “Lucas-critique-proof” way: given that employers know in advance they will not be able to cut wages in the future, how does this affect present wage-setting policy, and what are the effects of this foresight and of inflation on employment and efficiency? I find that downward nominal rigidity restrains wages in the presence of uncertainty but that inflation does not necessarily mitigate this effect. The impact of inflation on employment and efficiency may be either positive or negative, and there are few simple threshold-type rules to determine which it will be in any given situation. Instead, the efficiency effects of inflation depend on the precise characteristics of the market in question.

Number of Pages in PDF File: 35

Keywords: Nominal Wage Rigidity, Inflation, Labor Markets

JEL Classification: J39, J42

working papers series