do firms slash wages during recessions (1)

Examining the Connection Between Average Real

Wages and Unemployment During the Great Recession

and RecoveryAditya Devineni & Michael Letts

VCU Econ 431Dr. Stratton

April 17th, 2015

Background● Despite marked improvements in the labor market,

average real wages have barely risen since the Great Recession.

● ASAD model normally suggests wage stagnation should be interpreted as indicative of an underutilization of available labor resources, since firms bid wages higher during high employment to attract employees.

Standard Unemployment Rate

Compensation of Employees: Wage and Salaries

● Is it possible the believed relationship between nominal wages and unemployment fails during recessions and recoveries, due to firm-behavior not being fully accounted for by the ASAD model . . . ?

● May part of the explanation for wage stagnation be firms are simply struggling to recoup losses from keeping wages intact after such a deep recession . . . ?

Theory● Sticky Wage Theory

○ Firms rarely slash wages.

○ Why? Primarily because of union contracts, fear of worker discontent and reduced output, and inter-firm politics.

● Pent-Up Wage Deflation○ Without slashing nominal wages, firms must recoup losses from keeping wages

intact over time and, consequently, will not be able to bid wages higher in response to labor market improvements.

● Ricardian Model○ Firm output is proven to be positively correlated with wages; as employee

productivity increases, wages also tend to increase. Firms have an incentive not to cut wages in order to keep output high.

Hypothesis and Methods● Hypothesis:

○ The correlation between average real wages and unemployment weakens considerably during recessions and throughout recoveries.

● Methods: ○ Data indexed to 2000, adjusted to 2000 dollars, and measured

quarterly.○ Analysis is split into four parts: Quarters 1 through 4, in order to

eliminate seasonal effects and glean closer insight into possible trends.

LiteratureHornstein, Andreas; Kudlyak, Marianna; and Lange, Fabian. “A New Measure of Resource Utilization in the Labor Market.” Federal Reserve Bank of Richmond. 18 Apr 2014.

Kudlyak, Marianna; Lubik, Thomas; and Rhodes, Karl, “How Should the Fed Interpret Slow Wage Growth?” Economic Brief, No. 15-20. Feb 2015.

Yellen, Janet L., “Labor Market Dynamics and Monetary Policy,” Remarks at the Federal Reserve Bank of Kansas City Economic Symposium in Jackson Hole, Wyoming. 22 Aug 2014.

Purpose

● Federal mandate of maximum employment means analyzing various labor metrics is imperative to fully understanding actual labor market conditions and subsequent policy decisions.

● Previous assumptions about the relationship between wages and unemployment may obfuscate interpretations of the labor market and lead to misinformed policy decisions.

Conclusion● ASAD model does not fully account for firm behavior. Consequently,

the model misrepresents actual trends between average real wages and unemployment.

● We predict the relationship between average real wages and unemployment weakens considerably during recessions and throughout recoveries, since firms do not slash wages and must recoup losses.

● Hence, wage stagnation is likely due to pent-up wage deflation; not a gross underutilization of available labor resources, as many economists have portended in the past.