The Costs of Price Stability: Downward Nominal Wage Rigidity in Europe

Abstract

In most European countries, the prevailing terms of employment, including the nominal wage, can be changed only by mutual consent. This legal feature gives workers a strategic advantage in wage negotiations when employers push for a nominal wage cut. The upshot is a long-run trade-off between inflation and unemployment for low levels of inflation, in spite of all agents being rational and with no expectational errors. Specifically, downward nominal wage rigidity and excess unemployment at zero inflation are related to three factors: the coverage of collective agreements, the legal framework at contract renewal, and the strictness of the employment protection legislation for non-union workers.