Question

Identify and discuss three causes of wage stickiness. Explain how the speed of adjustment of wages informs policy makers about the possible effectiveness of fiscal and monetary policy with respect to output, unemployment and inflation.

Answer 1

Solution:-
Wage stickiness exists when the laborers earning do not adjust with changes in the labor market conditions.

The 3 broad reasons for wage stickiness are:

1)Imperfect Information

Nominal wages tend to increase when the price level increases. Workers, hence tend to believe that their real wages have increased and are willing to put in more effort. In the short run, till the time workers realize their mistake of considering nominal wages the same as real wages, There is increase in output and decrease in unemployement. Hence, wage stickiness arises from workers slow reaction and imperfect information.

2) Co-ordination Problem

There is a positive relation between the price level and the money supply. When one organisation increases their price and others do not, the one that does increases its price will loose business. On the other hand if all increase rices together, a new equilibrium price will be established. The coordination problem exists since wages are sticky at the bottom . If one firm cuts wages as a result of reduced demand, workers will get frustrated and leave the firm. hence, as a result of the coordination problem, wages go down slowly.

3)Efficiency Wage theory

The theory states that wages are one way to motivate workers to improve their efficiency. Higher wages will boost an employees morale and encourage them to stay in their job.

If the wages quickly adjust , there would be no coordination problem and imperfect information in the economy. The fiscal and monetary policy will be effective and the output will be in equilibrium.