Saturday, 18 February 2017

The NAIRU and Nominal Wage Rigidity

Simon Wren-Lewis has a post discussing the NAIRU.  He acknowledges that it has its problems but struggles to find a good alternative.

The idea with the NAIRU is that, when unemployment falls below that level, we don't simply have a higher rate of inflation, we have an ever increasing rate of inflation.

The theory here is that wage inflation reflects an attempt by workers to secure a particular real wage, based on their expectations of price inflation.  If they are thwarted by price inflation higher than expected they will revise their expectations and increase their demands.

However, whilst wage inflation may sometimes be driven by real wage concerns, it is not clear this should generally the case.  Particularly at lower levels of inflation, changes in aggregate wages may have little to do with real wage considerations.

First of all, it is worth noting that the inflation rate, and the rate of wage inflation, are aggregate figures.  At any time, some firms will be facing supply constraints and will be bidding up wages.  Others will find themselves with excess capacity and will be holding wages constant (or in rare cases, cutting them).  The balance will vary with the level of aggregate demand.  There isn't a single labour market and a single wage.

One of the reasons why the idea of a single wage might be unhelpful is to do with nominal wage rigidity.  On the whole, wages are not subject to constant revision.  An individual worker's wage is fixed when he is first employed and then only changed when there is sufficient reason to do so.  

At low inflation rates, therefore, most wage inflation arises from the turnover in jobs, where some firms are hiring and others are firing.  The lower the level of unemployment, the more that turnover requires hiring firms tempting workers to change jobs, rather than simply drawing on the pool of unemployed.  This requires greater wage differentials.

Actual cuts in nominal wages are unusual.  Having greater wage differentials therefore requires having a higher minimum average level wage inflation when unemployment is lower.  The higher average means the wages that are growing the least are not actually falling.

Real wages play no role in this.  It is all to do with relative wages.  So there's no question of foiled expectations or any reason to think that this inflation should accelerate.

All this means that, at low rates of inflation, we may well have some kind of trade-off between unemployment and inflation, rather than the accelerating inflation dictated by the NAIRU.  However, if higher rates of inflation become the norm, this kind of relationship may break down.  If the average rate of wage inflation is high, then cuts in relative wages can be easily achieved simply by holding some nominal wages fixed for longer.  The pay-off between inflation and unemployment depends on the reluctance to cut nominal wages being relevant.

Furthermore, if it becomes normal to frequently adjust wages to compensate for price inflation, then some measure of indexed wages starts to replace the fixed nominal anchor as the benchmark for relative wage competition.

So, accelerating inflation may still be a trap to fall into.  However, as conceived here, this does not simply arise from venturing past the NAIRU.  It comes from allowing inflation to persist at too high a level and for too long.  It is true that this could come from trying to achieve excessively low unemployment.  But wages are not the only factor in determining price inflation.  Things like exchange rates and world commodity prices also play a role.  On the whole, it should be no surprise that it is difficult for advocates of the NAIRU to pin down what the level of the NAIRU actually is.


  1. When I read SWL's piece I wondered about how they managed to have genuinely full employment and minimal inflation during WWII. The answer seemed to be a population loyal to price controls and rationing. People made patriotic pledges to never pay buy black-market goods. So I guess that isn't relevant for normal life. I guess Singapore manages to have near full employment for citizens but has a vast reservoir of guest workers who migrate in and out as employers dictate.

  2. I was wondering whether something closer to full employment might be achievable if workers got a greater proportion of pay in the form of profit share type bonuses. I guess investment bankers, workers in John Lewis Partnership and US workers in the United Autoworkers Union get in effect profit shares of that type. Perhaps then workers would demand greater shares of the profits rather than demanding nominal wage increases. Firms with excess personnel would get lower profits and that would lead to workers quitting and moving off to new recruiters but hopefully without entailing accelerating inflation or unemployment.

    1. From the 1955 Liberal Party manifesto "To obtain greater productivity we must give to capital both the reward of risk and the incentive to save - accepted in principle by Labour but fiercely resisted in practice - and we must give to workers the assurance of being partners in industry, entitled to their share in the fruits of prosperity. The Liberal Party alone has been advocating the general introduction of co-ownership schemes, desirable not only as incentives but as the foundation of industrial peace."
      But I've no idea how they were proposing to ensure such schemes were implemented. John Lewis Partnership came about as a result of the private owner being a kind-hearted eccentric. I think the Detroit car makers suggested the scheme the United Auto Workers have back when the UAW had a strangle hold.

    2. There's probably always going to be some pay-off between unemployment and inflation. The question is whether that is a pay-off against stable inflation or against accelerating inflation. And what tips you into the latter is when you have people chasing inconsistent targets for real values. So profit-sharing type arrangements might help, but I'm not sure they get round that.

    3. I thought it might get around the problem due to the bargained for compensation not being a fixed nominal value. If a union, in a system like UAW has, is in a strong position, then they will force a firm to say pay out 25% of profits to the workers. Whether the workers have expectations of high inflation or low inflation will make no difference to whether they demand 25% rather than say 20% or 30%. By contrast if the union is in a strong position and forces a traditional pay rise, then what constitutes an acceptably large pay rise will be very different depending on inflation expectations. Am I in a muddle about that?

    4. I don't know really. For what you're saying to apply, it would have to cover the vast majority of pay. It would potentially remove the scope for incompatible conflicting claims, which is often said to give rise to inflationary spirals. But it would do so by removing much of the nominal anchor provided by the rigidity of nominal wage contracts. It could go either way.

    5. I was drawn back to this after re-reading . I guess the end of the 1970s saw a turning point where union power was cut back and the labour share of production started falling. I'm still wondering whether the 1970s oil shocks might have been better absorbed if there had been worker co-ownership schemes. If a firm has a shock increase in raw material costs (eg oil price etc), then that has to be absorbed somewhere. In the 1970s, it was passed on by raising prices and perhaps partly by laying off workers. Perhaps, with co-ownership, it might have been absorbed as a hit to profits because the fixed wage bill would have been much lower since much of the workers' benefits would be through profit share rather than fixed wages. Ultimately, one way or another, the oil producers were going to be taking more; the issue is how to cope with that without causing accelerating inflation or mass unemployment or increasing inequality and impaired job security.