Real Wage and the Classical, Keynesian, and New Keynesian Perspectives - Literature review Example

Real wage and the ical, Keynesian, and New Keynesian perspectives The short-run fluctuations in output and employment constitute the business cycle (Mankiw, 2003, p. 238). Although Blanchard (2003, p. 519-521) talked of a political business cycle, Mankiw (2003, p. 238) clarifies that although the term "business cycle" suggest that economic fluctuations are predictable, they are actually not. Over a business cycle, real wage is expected to be acyclical in the Classical model, countercyclical in the Keynesian model, and procyclical in the New Keynesian model. Acyclical, countercyclical, and procyclical predictions are likely rooted in the school of thoughts assumptions on the economic agents at work. A classical model assumes that economic agents have perfect information. This being the case, economic agents will have no monetary illusion of value and will value in terms of the real and, therefore, real wage will be likely acyclical over the business cycle. Traditional Keynesians assumes that economic agents have imperfect information and will likely see illusions in nominal values. Thus, there can be countercyclical movement in real wage as output increases and as the full employment level affect the nominal wage. In the New Keynesian model, however, agents have rational expectations. Economic agents can commit mistakes but they will not commit the mistakes systematically or repeatedly. Empirical evidence provides support for both a countercyclical and procyclical real wage over a business cycle but the balance of evidence provides greater support for procyclical real wage. We review some of the studies on the cyclicality, acyclicality, and countercyclicality between real wage and the business cycle. We begin with Kiley (1997). According to Kiley (1997, p. 1, 4), the classical view of acyclical real wage can be explained as follows: Efficiency wage models reduce the effects of real wages on real demand and can explain acyclical behaviour of real wage and employment changes in a business cycle. When workers are paid efficiency wages, price stickiness does not emerge but "acyclical real wage and large employment fluctuations arise". Earlier literature on acyclical real wage in an efficiency wage model succeeded in generating acyclical real wage through a "countercyclical effort". Returns to labour and elasticity of labour supply determine cyclicality in marginal cost. However, because many of the estimates of elasticity of labour supply are low, many economic models were unable to depict price stickiness thereby resulting to acyclical real wage. Provision of efficiency wages by employers caused the weakening of the link between work effort and real wage. With a weakening of the link, a cyclical real wage is not manifested thereby exhibiting acyclical real wage movement over the business cycle. Kiley asserted that his model based on Solow (1979) is capable of generating acyclical wages based on efficiency wage models (1997, p. 6). Kiley elaborated that, similarly, "acyclical real wage requires countercyclical effort and hence procyclical marginal cost" (p. 9). Kiley also argued that the earlier literature on acyclical real wage was founded on such countercyclical effort and procyclical movements. The earliest study on real wage cycle is that of Tarshis (1939) who found that Keynes view of countercyclical movement of the real wages along the business cycle does not have adequate empirical support (Ostrok & Pourpourides, 2008, p. 4). According to Ostrok and Pourpourides (2008, p. 4), many economists have accepted an acyclical movement of the real wage as a "stylized fact" of the business cycle because the "simple average" of real wages does not appear to move in a pattern. However, various studies have "found" or argued that wage acyclicality is a statistical illusion and that the movement of real wages in a business cycle is strongly procyclical (Ostrok & Pourpourides, 2008, p. 4, citing the work of Bils 1985, Solon et. al. 1994, and Ziliak, et. al. 1999). Fleischman, as early as 1999 (p. 1), reported that a models ability to explain pro-cyclical movement in real wages has become an important standard in judging business cycle theories. However, Keynesian models chose to stick on models revolving on price stickiness. Consequently, Keynesian models were criticized in favour of Real Business Cycle models. Citing McCallum (1986), Fleischman (1999, p. 1) pointed out the shortcomings of real wage models that assume sticky prices: Countercyclical movements in real wage have not been observed to warrant adherence to the model. Models that imply cyclical movements in labour supply will generate countercyclical movements in real wage but that, too, have not been observed. Based on studies, single shock Real Business Cycle models will also lead to procyclical not countercyclical movement in the real wage. According to Fleischman (1999, p. 1), the main evidence for procyclical real wage over the business cycle can be found in the works of Bil (1985) and Solon, et. al. (1994). The said studies overthrew the earlier findings of countercyclical real wage. According to Fleischman (1999, p. 1), the following can cause disturbances that can start a business cycle. Monetary disturbance. Credit shocks. Consumer shocks Loss of consumer confidence Technology or productivity shocks Taste shocks Labour supply shocks Oil price shocks Exchange rate shocks With regard to the business cycle, Fleischman (1999, p. 2-3, 6) argued the following: Real wage cyclicality depends on the shocks driving the business cycle. Real wages will be procyclical given a technology and oil price shocks but mildly countercyclical to labour supply and aggregate demand shocks. The various types of shocks that can drive a business cycle produce different correlation between real wage and output and the correlation can lead to countercyclical or procyclical response of real wage. The business cycle is the way of the market to adjust to shocks. In producing insights on the business cycle, Fleischman used a model that employed measures of conditional wage cyclicality (p. 2). In his view, cyclicality in the real wage is represented by the correlation between the forecast errors of output and real wages (Fleischman, 1999, p. 2). In Fleischmans notion, there are three types of aggregate supply shocks (labour, technology, and oil price shocks) and two types of demand shocks (Fleischman, 1999, p. 2). The two demand shocks in Fleischmans model were nominal inflation and the real rates. In addition to aggregate supply and demand shocks, Fleischman (p. 3) added a sixth shock called structural shock that is represented by labour or wage share. The empirical study of Messina & others (2009, Abstract and p. 5-6, 21-23, 25) obtained mixed results but the balance of evidence favours more a countercyclical real wage movement along a business cycle. However, the authors emphasized on the following: Empirical evidence on the response of real wages over the business cycle is inconclusive. Data and methods determine whether cyclicality of real wage over the business cycle will be observed. However, economies that are more open and nations with strong labour unions tend have less pro-cyclical real wages over the business cycle. In other words, this means that in these countries, real wage tends to be more counter-cyclical. In situations where real wages tends to be cyclical over the business cycle, there is a positive correlation between real wages and employment. Messina & others interpreted the situation as one where policy complementation may be influencing adjustments (quantity and prices) in the labour market. They also interpreted their data to mean that that there is a positive correlation between cyclicality of real wage versus cyclicality of employment. Cyclicality of real wage diminishes or becomes more countercyclical when the wage measure is deflated using producer prices rather than other deflators. The authors interpreted their data to mean that differences in deflators would result to robust differences. While dynamic methods may be more accurate, cyclicality does not depend on whether cyclicality is assessed in the short-run or long-run. Countries with real wage rigidities are less likely to have a pro-cyclical and more likely to have a more likely to have a counter-cyclical real wages at the aggregate level. There are three groups of countries: 1) Countries with pro-cyclical real wages along the business cycle; 2) Countries with mainly counter-cyclical real wages; and 3) Countries with either a-cyclical real wage or with a unique pattern of cyclicality across deflators. Data and results indicate a negative association between unionization or trade openness and cyclicality of real wage. Using a summary measure of cyclicality of employment, they found that cyclicality of employment and real wages are positively associated. Economies that are more open and those with strong labour unions tend to be less pro-cyclical or more counter-cyclical. The study of Messina & others (2009) summarized various researches conducted by the Wage Dynamics Network (WDN). The WDN is a network of economists of the European Central Bank and the central banks of member countries of the European Union. In addition to this, the paper benefited from the inputs of referees considered to be among the top economists of the European Union: Gabriel Fagan, Philip Vemeulen, Giuseppe Bertola, Jan Babeky, Herve Le Bihan, and Thomas Maltha. Using longitudinal micro data and a dynamic factor model, Ostrok and Pourpourides obtained mixed results but, in contrast with the work of Mesina & others, they interpreted their work to mean the following (Ostrok & Pourpourides, 2008, Abstract and p. 1, 4, ): Roughly half of real wages move cyclically and the other half, countercyclically. The dynamics are consistent with a Walrasian labour market. The findings of earlier studies that skilled and unskilled labour market has the same degree of cyclical variation are confirmed/validated. Assuming implicit contracts, the theory of acyclical real wage over the business cycle finds support. Workers of various skill grades have no distinct real wage cycles. Earlier, Swanson (2007) also obtained mixed results. Using a Panel Study of Income Dynamics (PSID), Swanson found that although real wages were procyclical among the all workers from 1967 to 1991, the wages of low-income, young, and less-educated workers were more procyclical (see abstraction section of Swanson, 2007). Swanson also found that real hourly wage rates are acyclical and interpreted this to mean that variable pays such as bonuses, overtime, late shift pay, and commissions have been playing an important role in procyclicality (see abstract section of Swanson, 2007). According to Swanson (2007, p. 1), a countercyclical movement between real wage and employment is being predicted by Classical, traditional Keynesian, and also by the more modern Dynamic Stochastic General Equilibrium (DSGE) models "in which technology shocks plays only a minor role". Swanson (2007, p. 1) attributes to John Maynard Keynes the remark that "for a given organization, equipment, and technique, real wages and the volume of output (and hence of employment) are uniquely correlated, so that, in general, an increase in employment can also occur to the accompaniment of a decline in the rate of real wages". This is the likely origin of the notion that traditional Keynesian economics consider a countercyclical real wage over a business cycle. Swanson (2007) has nice graphics on the movement of real wages over time in the conditions of the United States that can be interpreted as support on either the procyclicality or countercyclicality of real wage. One set of graphics is in Swanson 2007, page 13, that is shown here as Figure1. Figure 1: Distribution of real wages over time Source: Swanson (2007, p. 13, "Figure 7: The Distribution of Real Wage Changes Over Time) In the search for explanation on the procylicality of the real wage over a business cycle, Swanson did not find oil prices as a significant explanation (p. 15). He said that although oil prices showed significant spikes near recessions, the timing does not coincide with the wage data. Further, the large declines in the oil prices of the 1980s are not consistent with the wage figures (Swanson, 2007, p. 16). In what may open a continuing research on real wage cyclicality, Swanson also found that various demographic groups appear to have their own real wage cyclicality. One of the stylized facts is captured in Figure 2 of this work which is from Swanson (2007, p. 28). Swanson (2007) has actually several figures or graphs on the role of demographics on the cyclicality of real wage. These are discussed and illustrated on pages 25-29 of his work. Figure 2. Wage cyclicality of demographic groups Source: Swanson (2007, p. 28, Figure 14) Most likely, research on the business cycle and cyclicality of the real wage is not over. Bibliography Blanchard, O. (2003). Macroeconomics (3rd ed). New Jersey: Prentice-Hall. Bils, M. (1985). Real wages over the business cycle: evidence from panel data. Journal of Political Economy, 96(6), 666-689. Kiley, M. 1997. Efficiency wages, nominal rigidities, and the cyclical behaviour of real wages and marginal costs. Washington: Federal Reserve Board. McCallum, B. (1986). On real and sticky-price theories of the business cycle. Journal of Money, Credit, and Banking, 18(4), 397-414. Mankiw, N. G. (2001). Principles of macroeconomics (3rd ed). New York: Worth Publishers. Mankiw, N. G. (2003). Principles of macroeconomics (5th ed). New York: Worth Publishers. Messina, J., Strozzi, C., & Turunen, J. (2009). Real wages over the business Cycle: OECD evidence from the time frequency domains. European Central Bank: Wage dynamics network. Ostrok, C. & Pourporides, P. (2008). The cyclicality of real wage and wake differentials. Unpublished paper. Solon, G., Barsky, R., Parker, J. (1994). Measuring the cyclicality of real wages: how important is composition bias. Quarterly Journal of Economics, 109 (1), 1-25. Solow, R. (1979). Another possible source of wage stickiness. Journal of Macroeconomics 1, 79-82. Swanson, E. (2007). Real wage cyclicality in the PSD. San Francisco: Federal Reserve Bank of San Francisco. Tarshis, L. (1939). Changes in real and money wages. Economics Journal, 49, 150-154. Ziliak, J., Wilson, B., & Stone, J. (1999). Spatial dynamics and heterogeneity in the cyclicality of real wages. Review of Economics and Statistics, 81 (2), 227-236. Read More