Low And Stable Inflation Eases Labour Market Adjustment In A Downturn

Low and stable inflation is crucial in allowing the labour market and hence the wider economy to adjust in the face of a downturn. That is one of the conclusions of series of studies published in the November 2007 issue of The Economic Journal.

The research looks at evidence on the causes and consequences of downward wage rigidity (where workers resist pay cuts) in three major European countries – Britain, Germany and Italy. They suggest that an environment of moderate inflation may help to obtain wage outcomes that are  favourable for economic performance by minimising the adverse effects of wage rigidities.

The rate of inflation serves as benchmark for most wage negotiations. In addition, the link between inflation and wages is one of the most important channels through which inflation affects the wider economy.

Wage flexibility is crucial in allowing the economy to adjust to shocks and the business cycle. If workers resist a cut in their money wage in response to a downturn (''nominal wage rigidity''), then this can result in unemployment.

Inflation can lower the real value of a fixed nominal wage (as the same wage will buy fewer goods and services), so real wage adjustment can take place even if nominal wages do not fall.

But in the presence of high inflation, workers may be aware of rising prices and be less willing to accept wage increases below the level of inflation. This is known as ''real wage rigidity''.

If there is either nominal or real wage rigidity, then wages cannot easily be adjusted downwards. This means that unemployment will increase more than it otherwise
would during a downturn.

''Wage Rigidity: Measurement, Causes and Consequences'' by Lorenz Goette, Uwe Sunde and Thomas Bauer is published in the November 2007 issue of The Economic Journal.