Explaining Sticky Wage Theory

This short study note looks at sticky wage theory associated with Keynesian economics.

Problem: Unlike in other markets where prices freely adjust to supply and demand, wages often respond slowly to changes in the labour market. This sluggishness, termed "sticky wages," poses a challenge for economic stability.

Reasoning: Several factors contribute to stickiness:

• Institutional frictions: Labour contracts, minimum wage laws, and union presence can impede downward wage adjustments.
• Efficiency costs: Frequent wage changes disrupt workplace morale and productivity, making firms hesitant to cut pay.
• Loss aversion: Workers resist cuts as they perceive them as unfair and detrimental to their status and standard of living.

Consequences:

• Unemployment: During recessions, sticky wages might prevent labour market clearing at lower wages, leading to unemployment as firms choose layoffs over pay cuts.
• Slow recovery: As aggregate demand shrinks, sticky wages hinder aggregate supply adjustments, potentially prolonging periods of economic downturn.
• Inflationary pressures: Firms facing cost pressures from sticky wages may choose to raise prices instead of cutting wages, contributing to inflationary tendencies.

Policy implications:

• Demand-side policies: Keynesian theory emphasizes stimulating aggregate demand through fiscal and monetary measures to boost hiring and output, mitigating the need for wage adjustments.
• Income policies: Some Keynesians advocate for temporary interventions, such as wage-price controls, to address periods of severe economic disruption.

Criticisms:

• Empirical evidence: Some argue that while wage adjustments are not instantaneous, they are not as rigid as Keynesians suggest.
• Oversimplification: Critics claim the theory overlooks factors like wage differentiation and wage adjustments within firms.

Conclusion:

The Keynesian Sticky Wage Theory holds significant weight in macroeconomic analysis, highlighting the complexities of labour market dynamics and their interplay with economic fluctuations. Although debated, the theory continues to fuel policy discussions and guide interventions aimed at achieving full employment and economic stability.