Inflation and Wage Dispersion

Abstract

A large body of empirical work has demonstrated that higher inflation, especially when it is unexpected, leads to greater dispersion in the distribution of price changes across subaggregates. A sparse and more recent literature suggests exactly the opposite effects on the distribution of wage changes. This study first reconciles these apparently opposite results using a model in which shocks to the economy can affect both wages and prices and the demand for indexing. If the positive effect of shocks on the demand for indexing is sufficiently large, the dispersion of changes in wages or prices will be reduced even though the shocks' direct effect is to increase this dispersion. Implicitly from the evidence, this offset is large enough in wage-setting, but not so large in price determination. Additional evidence on the relationship between inflation and the dispersion of wage changes is provided by empirical work for 14 Israeli manufacturing industries, 1956-82. The results suggest that in Israel, just as in the United States (on which previous work has been conducted) with its much less rapid and variable inflation, dispersion also decreased with unexpected price inflation.