Gains from Wage Flexibility and the Zero Lower Bound*
| DOI | http://doi.org/10.1111/obes.12381 |
| Published date | 01 December 2021 |
| Author | Roberto M. Billi,Jordi Galí |
| Date | 01 December 2021 |
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©2020 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 82, 6 (2020) 0305–9049
doi: 10.1111/obes.12381
Gains from Wage Flexibility and the Zero Lower
Bound*
Roberto M. Billi† and Jordi Gal´
i‡
†Sveriges Riksbank, Stockholm, Sweden. (e-mail: roberto.billi@riksbank.se)
‡CREI, UPF and Barcelona GSE, Barcelona 08005, Spain. (e-mail: jgali@crei.cat)
Abstract
Weanalyse the welfare impact of greater wage flexibility in the presence of an occasionally
binding zero lower bound (ZLB) constraint on the nominal interest rate. We show that the
ZLB constraint generally amplifies the adverse effectsof g reater wageflexibility on welfare
when the central bank follows a conventional Taylor rule. When demand shocks are the
driving force, the ZLB implies that an increase in wage flexibility reduces welfare even
under the optimal monetary policy with commitment.
I. Introduction
Most mainstream economists view wage rigidity as an undesirable feature for an economy,
one that is likely to hamper macroeconomic stability and cause a high and volatile unem-
ployment rate. The perceived costs of wage rigidity rely on a logic based on the familiar
labour market diagram found in introductory textbooks: a decrease in wages should offset,
at least partly, the negative effects on employment (and output) of any adverse aggregate
shock that reduces labour demand. If wages are rigid and that adjustment does not take
place (or it is slow) the negativeemployment and output effects of adverse shocks are likely
to be amplified and unemployment will rise, at least temporarily.1
In the General Theory, Keynes (1936) already called into question the previous logic,
which he associated with ‘classical’ economics, and deemed it irrelevantto understand the
workings of modern economies. In his view, the wage level does not have a direct role in
the determination of employment. The latter is instead determined by aggregate demand
JEL Classification numbers: E24, E32, E52.
*We thank Pierrick Clerc, Yoon J. Jo, Michael Kumhof, Cristina Manea, Ales Marsal, Francesco Zanetti and
two anonymous referees for useful comments. Gal´ı acknowledges financial support from the Spanish Ministry of
Economy and Competitiveness, through an I+D Grant (ECO2017-87827) and the Severo Ochoa Programme for
Centres of Excellence in R&D (SEV-2015-0563). The views expressed herein are solely the responsibility of the
authors and should not be interpreted as reflecting the views of Sveriges Riksbank.
1See, for example, Hall (2005) and Shimer (2005, 2012) for a discussion of the role of wagerigidities in accounting
for labour market fluctuations in the context of the search and matching model. Blanchard and Gal´ı (2007, 2010)
emphasize the policy trade-offs generated by the presence of wage rigidities in a New Keynesian model. Zanetti
(2007) shows how wagesetting by unions can be a source of such wage rigidities.
1240 Bulletin
for goods. Accordingly, aggregate demand management, rather than wage flexibility, is
key to employment stability.
More recently, Gal´ı (2013) revisited Keynes’ argument through the lens of a standard
New Keynesian model with price and wage stickiness `a la Calvo, and in the absence of
a zero lower bound (ZLB) constraint on the nominal interest rate. Two results are worth
stressing from that analysis. First, the extent to whichg reater wageflexibility contributes to
employment and output gap stability hinges critically on the monetary policy rule in place.
More precisely, it is the strength of the central bank’s systematic response to inflation that
largely determines the response of aggregate demand to changes in wages.
Second, Gal´ı (2013) also shows an increase in wage flexibility tends to raise the volatility
of price and wage inflation, both of which are costly because they generate an inefficient
allocation of resources in the presence of staggered price and wage setting. Thus, if the
central bank follows a policy rule that calls for a relatively weak response to inflation,
the benefits of increased wage flexibility in the form of a more stable output gap and
employment will generally be small, and likely more than offset by the welfare losses
brought about by the more volatile price and wage inflation. However, when theTaylor rule
calls for a sufficiently aggressive response to inflation, or when the central bank follows
the optimal policy (with commitment), an increase in wage flexibility tends to improve
welfare, at least for reasonable calibrations of the economy’s parameters.
In the present paper, we extend the analysis in Gal´ı (2013) by taking explicitly into
account a ZLB constraint on the nominal interest rate, and study the role of that constraint
in determining the welfare effects from greater wage flexibility. The reason for focusing
on the interaction between wage flexibility and the ZLB is that the presence of the latter
may limit the ability of a central bank to respond to downwardpressures on wage and price
inflation in the face of a shock triggering such pressures. Our analysis seeks to assess the
extent to which the presence of the ZLB constraint may affect the gains (or losses) from
an increase in wage flexibility, under alternative monetary policy regimes (Taylor rule vs.
optimal policy) and sources of fluctuations (demand vs. technology shocks).
Several findings of interest emerge from our analysis, which we summarize next.
First, we show that a downward adjustment in labour costs (implemented through a
wage subsidy) in a recessionary environment with a binding ZLB may (unintentionally)
deepen the downturn, due to the implied procyclical response of the real interest rate when
the ZLB binds.
Second, we show that the main finding in Gal´ı (2013), namely that under a (realistic)
Taylor rule an increase in wage flexibility is welfare reducing, is robust to the presence of
the ZLB constraint. Most importantly for our purposes, we show that the ZLB constraint
generally amplifies the adverse effects of greater wage flexibility on welfare.
Third, when demand shocks are the source of fluctuations, we show that an increase in
wage flexibility is associated with larger welfare losses even when the central bank follows
an optimal monetary policy. However, this is not true for technology shocks.
Finally,we show that under a Taylor rule and conditional on either demand or technology
shocks, the introduction of the ZLB constraint (i) amplifies the increase in welfare losses
from a (local) simultaneous reduction in both price and wage rigidities and (ii) increases the
range of those rigidities for which welfare losses are decreasing in the degree of nominal
rigidities, relative to the case without ZLB constraint.
©2020 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd
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