The Effects of Wage Volatility on Growth

Abstract

This paper develops a theoretical model that identifies the relationship between the volatility of private sector wages and growth. The model suggests two distinct channels in which wage volatility affects growth: a positive direct way and a negative indirect way. The direct effect stems from precautionary savings, whereas the indirect effect works through the mediating role of government size. Our empirical part of applying a 3SLS approach to a panel of 20 high-income OECD countries provides strong evidence for the existence of both effects. Various robustness tests confirm the results. In addition, our data shows that the indirect effect is stronger in smaller countries with a population under 10 million people, whereas the direct effect is more significant in bigger countries.

Keywords: Growth, Volatility, Government Size, Wages

JEL Classification: C33, E20, O40