Employment Fluctuations and Wage Rigidity

Abstract

Emqployment Fluctuations and Wage Rigidity DURING the past decade, two facts about the U.S. labor market became more apparent than ever before: the large magnitude of fluctuations in employment and the lack of any strong response of wages to these fluc-tuations. The year 1975 saw the most striking manifestations of these features. Total labor input to the private economy fell by 6 percent from a year earlier (relative to trend growth), while wage inflation continued at close to its rate in the preceding boom. Although macroeconomists have puzzled over these characteristics ever since the discipline came into being, efforts redoubled in the 1970s to provide a solid economic rationale for the insensitivity of wages to current economic conditions and for the conspicuous deviations of employment from the smooth trend predicted by simple theories of economic growth. Ten years ago macroeconomists were satisfied with a simple idea that had become virtually the ruling doctrine after Keynes-money wages are predetermined, or at least are quite unresponsive to current economic conditions. Firms set employment unilaterally by hiring up to the point where the marginal revenue product of labor equals the sticky wage. If nominal aggregate demand falls, employment falls. This idea inhabits every textbook in intermediate macroeconomics and underlies much pro-fessional analysis. But a defect in this line of thought has been apparent for many years, and has become more of an embarrassment to macro-The author is grateful to the National Science Foundation for financial assistance. I thank James L. Medoff, Ben S. Bernanke, and members of the Brookings panel for helpful comments, and Ben Craig for assistance. 0007-2303/80/0091-0123$01.00/0 ? Brookings Institution 92 Brookings Papers on Economic Activity, 1:1980 economics as the field has drawn closer to microeconomics: whenever inadequate demand pushes employment below its market-clearing level, economic inefficiency results. If workers and employers could get together and agree on the level of employment, they would equate the marginal revenue product of labor not with the wage but with the marginal value of workers' time. Employment would not be distorted by a sticky money wage. Demand and supply would have equal roles in employment de-termination, instead of the predominance of demand as in traditional macro theory. Serious investigation of the idea that there are better ways for workers and employers to deal with each other as aggregate demand varies has led in a number of directions. In order to understand most of the new ideas, it is important to keep in mind another fact about the U.S. labor market-most workers hold jobs for quite a few years. Employers and workers typically have long-term relations with each other. One of the most sig-nificant lines of recent thought pursues the implications of this important fact. Wages are insensitive to current economic conditions because they are effectively installment payments on the employer's obligation to trans-fer a certain amount of wealth to the worker over the duration of the employment arrangement. A major corollary is the limited allocational role of the wage payment for employment. The rule of the open market-set the value of the marginal product of labor equal to the current wage-no longer has meaning when the current wage is a more or less arbitrary payment on a long-term obligation. Instead, the more fundamental prin-ciple of equating the marginal revenue product to the marginal value of labor's time should govern. This basic condition of economic efficiency is the starting point for recent thought on employment fluctuations within long-term employment arrangements. In this paper much of the discussion is devoted to the issue of employ-ment efficiency. It is one thing to argue that employment arrangements at the level of the individual firm result in an efficient flow of labor services from one worker to that firm, and quite another to argue that the total flow of labor services from all workers to the aggregate economy is efficient. What I call the micro efficiency condition requires that the employment level equates the marginal product of labor with the marginal value of time; it seems to explain a lot about the institutional arrangements for employment determination. The macro efficiency condition is much more