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How Rigid Wages, with Low Inflation, can Worsen Unemployment

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
May 2006
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Countries usually consider low or moderate inflation an important goal, but can it, in certain situations, have harmful side effects? A recent IMF Working Paper by intern Shintaro Yamaguchi looked at the role played by wage inflexibility in labor market performance in Central and Eastern Europe, particularly Poland. He finds that reduced inflation after 1998, in conjunction with downward nominal wage rigidity, did indeed contribute to a higher unemployment rate in Poland.

Flexibility allows wages to adjust to equilibrate supply and demand. If wages are flexible, labor can be allocated more efficiently across sectors, skill categories, and geographical regions, and can enable an economy to absorb shocks more effectively and adjust to structural changes. Flexible wages can also help shorten the transition period in economies undergoing profound structural adjustments.

In many countries of Central and Eastern Europe, labor market performance has failed to improve in recent years, with unemployment remaining high even though the transition to a market economy is almost complete in some countries and growth has picked up. Has wage rigidity played a part in the region’s ongoing weak labor performance? Has wage flexibility worsened over time?

Real wage sensitivity to unemployment

To answer these questions, Yamaguchi modified the conventional measure of the sensitivity of real wages to unemployment (also known as the wage curve approach—referring to the curve showing how real wages depend on the unemployment rate), compared this sensitivity internationally, and traced its evolution over time. The extent to which real wages respond to changes in labor market conditions is particularly relevant in Central and Eastern European countries because differences in unemployment are large.

The region has shifted from an environment of high inflation and high wage growth to one of moderate or low inflation and wage growth. Because the inflation environment has changed, the flexibility of real wages may also have changed. A standard assumption by economists is that the responsiveness of real wages to changes in the unemployment rate is the same at different unemployment levels. In a high-unemployment, low-real-wage environment, however, real wages may be relatively unresponsive to changes in unemployment. It is also important to understand how real wage rigidity is related to nominal wage rigidity and inflation. A common assumption when economists measure nominal wage rigidity is that the sectoral distribution of nominal wage rate changes is stable over time; but, in fact, that is unlikely to be true in countries undergoing turbulent transition.

To gain a better understanding of wage flexibility in a turbulent environment, Yamaguchi modified these standard approaches to take into account instability in the sectoral distribution of nominal wage changes, comparing the actual distribution of nominal wage changes to a hypothetical case with no rigidities. If the two were different, he concluded, it would provide prima facie evidence that rigidities play a significant role.

The case of Poland

Yamaguchi’s modified approach makes it possible to understand real wage rigidities in Central and Eastern Europe. Using sectoral data for Poland, it confirmed that real wages were less flexible when unemployment was high and real wages were low. Notably, the wage curve in Poland was almost flat—with no variation in real wages—when the unemployment rate was high (above 14 percent) but fairly steep when the unemployment rate later fell.

Comparing wage-change distributions in the two periods, Yamaguchi concluded that the effects of nominal wage rigidities on real wages and, thus, on the labor market and the economy were small until 1998 but quite significant thereafter. Before 1998, high average wage growth and high inflation shielded the Polish labor market from the negative consequences of downward nominal wage rigidities. As reforms proceeded, the source of rigidities started to disappear at the local level, and wages became more flexible after 1998.

After 1998, however, low average wage growth, low inflation, and downward nominal wage rigidity hindered real wage flexibility. This means Yamaguchi found that adjustment took place through a rise in unemployment rather than through downward adjustment in real wages. In Poland, downward nominal wage rigidity in an environment of low inflation thus prevented the type of adjustment that did the trick in the labor market before 1998. The result was high unemployment.

Copies of IMF Working Paper No. 05/134, “Wage Flexibility in Turbulent Times: A Practitioner’s Guide, with an Application to Poland,” by Shintaro Yamaguchi, are available for $15.00 each from IMF Publication Services. Please see page 144 for ordering details. The full text is also available on the IMF’s website (www.imf.org).

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