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Wage Flexibility And The Rate Of Inflation In The UK

A surprisingly high proportion of British employees experience pay cuts, according to new research by President of the Royal Economic Society Professor Stephen Nickell and Glenda Quintini, published in the October 2003 Economic Journal.

Their findings run counter to the conventional view that nominal wages are ''downwardly rigid'' – in other words, unlikely to fall. ''Wage flexibility in Britain is high enough to eliminate the desirability of having an inflation target higher than its current modest level'', the researchers conclude.

It is commonplace for economists to assert that nominal wages are downwardly rigid – that is, that employees do not face falls in their nominal pay from one year to the next. Using data from the UK New Earnings Survey for a 25-year period from the mid-1970s, Nickell and Quintini find that this assertion is false.

For example, comparing the hourly rate of pay received by individuals in fulltime work in a given week in April with the hourly rate in the same week in the following year, during the low inflation period 1993-9, 19% of those remaining in the same job experienced a pay cut. Not surprisingly, pay cuts are more than twice as likely among those who receive an element of incentive pay in their weekly pay than among those who do not.

Despite this, there is some degree of rigidity in the sense that there is a significant group of full-time workers (around 4% of those who did not change jobs) whose nominal hourly rate of pay is exactly the same from one year to the next. So in the distribution of annual changes in nominal hourly pay, there is a highly significant ''spike'' at zero.

Not surprisingly, when inflation is high, the size of the group with ''rigid'' nominal wages tends to be much smaller than when inflation is low. For example, the 4% number noted above is for the period 1993-9. During the high inflation period 1975-81, only 0.7% of workers who did not change jobs had unchanged pay from one year to the next.

One of the consequences of the commonplace view that nominal wages are downwardly rigid is a belief that some degree of inflation is good for the economy. For if the economy is subject to an adverse shock, a fall in real
wages may be necessary to maintain full employment.

If there is no inflation and nominal pay cannot fall, then real wages cannot fall either and there will be a rise in unemployment. On the other hand, if inflation is significantly positive, real wages can fall even if nominal wage changes cannot be negative.

Since there is some small but significant degree of nominal wage rigidity at zero, does this mean that higher average inflation would lead to a more ready downward adjustment in real wages in response to adverse shocks and lower average levels of unemployment?

The measurements reported in this study reveal that this effect is very small in practice. Were the target inflation rate to be raised from 2½% to 5½%, a substantial increase, the fall in the average rate of unemployment would be
only a little above one tenth of one percentage point.

In conclusion, therefore, wage flexibility in Britain is high enough to eliminate the desirability of having an inflation target higher than its current modest level.

''Nominal Wage Rigidity and the Rate of Inflation'' by Stephen Nickell and Glenda Quintini is published in the October 2003 issue of the Economic Journal. Nickell is President of the Royal Economic Society, Professor of Economics at the London School of Economics and a member of the Bank of England''s Monetary Policy Committee; Quintini is at the OECD in Paris.