Question

7. Policy Topic: We have a recession. What do I need to know about “sticky wages?” a. Explain the concept b. Describe and analyze all of the theories cited about why wages might be “sticky.” c. How do “sticky” wages play a large role in policy effectiveness? d. How does this concept change the policy approaches of Keynesians and Classicalists?

Answer 1

Sticky wages or stickiness of wages refers to the slow-paced changes in wages as a result of changes in the economic conditions. Generally, wages rates are said to be 'stickydown'. This means that they are relatively slower in downward movement than they are in the upward direction. In other words, wages usually rise faster than they would fall.

The concept of sticky wages is that nominal wages resist changes in the market conditions. They are rigid and do not fluctuate based on changes in economic conditions. For instance, in the case of a recessionary period, the wages rates do not fall as expected due to slowdown of economic growth. Likewise, during an inflation, they do not rise keeping pace with the price rise.

Reasons for Stickiness of wages:-

• Lack of knowledge about the market:- Workers are ready to work harder as their nominal wage rates go up. They, however, do not realize that the price levels have also increased. This means that their real wage rates have not necessarily increased as much. In fact, an increase in wage rates in the short run will result in increase in labor input costs for the company and since the wages are sticky, firms would cut jobs instead of cutting the wage rates. This means more unemployment.

• Lack of coordination:-- When there is an increase in the money supply in the economy, the price levels rise as a result of more money chasing less goods. The output level does not change much. The increase in price levels happens at an aggregate level and not just because of an individual firm. A single firm will not increase its prices due to the fear of losing its customers. Firms are slow in adjusting their prices as they would try atmost to get more profits by selling more at lesser prices. When there is a fall in demand due to overall rise in price levels, the firms do not immediately cut wages as the workers would leave the company and move to another one. A cut in wage rates must also happen at an aggregate level for it to be effective. Hence, wage rates are stickydown.

• Efficieny theory:- When workers are paid well , their productivity is high and it results in more output and profits for the firm. A low paid worker would leave the firm or become less efficient. The costs of hiring a new labor and training that individual is high. And hence, companies do not opt for wage cuts. Infact, wages generally follow an upward trend.

Policy effectiveness and sticky wages:- Assume the government increases the money supply in the economy. This would result in increased consumption which is met by a rise in income levels. At the consumer level this results in an increased nominal wage rate. This is because the government increases money suppy to increase economic activity to boost its growth rate. While the firms want to invest the money available in the form of expansionary activities, for example by increasing wage rates to increase productivity to meet the growing consumer demands. Sticky wages ensure that the workers do not get affected by the increase in money supply which would lead to an increase in price levels.

With respect to fiscal policy matters such as an increase in tax rates would not affect the consumption levels by a large margin as the firms do not cut wage rates due to the rise in taxes. This reflects in the pricing of the products. Consumers in general due to the lack of understanding of the markets do not change drastically their consumption patterns as they are mostly unaware that their real wage rates have not risen that much.

Keynesian vs Classicalists:-

Keynesian school of thought places significance on the government intervention in the markets. A change in price levels could be dealt with by fiscal or monetary policy measures. Now, as we know that wages are sticky, the government would be able to effectively introduce policy measures to influence the economic conditions or the movement of the market. This is the way Keynesians would view economic policy measures keeping in mind stickiness of wage theory. Keynesians look at short term effects.

Classical school of thought, proposed by Adam Smith, looks at providing long term solutions to economic situations. In this school of thought factors such as inflation, unemployment and regulations are taken into account while framing policies. It is believed that markets are self regulating and there is not much that the government can do to influence the markets. If at all any, it would harm the flow. Stickiness of wage theory as explained above would influence firms to change its output levels and cut employment to deal with a rise in costs, but not the wage rates as it would lose its workers to another firm, thereby reducing its competitive edge. Classicalists would alter supply and technological inputs to deal with economic situations than cutting wage rates.