The concept of real wages has increasing significance in the current world. Rising inflation and recession in almost all major economies have led to the importance of studying real wage with respect to prices and economies themselves. Such a study would require an in-depth understanding of the business cycle of real wages. From Classical theory to New Keynesian theory, Cyclicality of real wage has been defined in contrasting terms. Much of the conflicting evidence is simply characteristic of empirical research. Researchers use different model specifications and estimation techniques. Empirical results are often sensitive to the choice of cyclical indicators and time period chosen (Dimelis, 2007).
This essay seeks to explain why real wage is expected to be acyclical in the classical model, counter-cyclical in the Keynesian model and procyclical in the New Keynesian model and shed light on which model best fits empirical evidence.
Real wage is defined as the “wage paid to the average worker divided by the price level.”(Delong and Olney,2006 p.535) It therefore measures the cost of labour in real terms as it is the number of units of output that can be exchanged for one time-based unit of work.(Levacic and Rebmann, 1982)
The Classical Model
In the classical model, the basic assumption is that prices and wages are flexible. The basis of classical theory is that the markets work perfectly, that prices adjust rapidly to cover any gap that may arise due to a difference in the quantities demanded and supplied. (Delong and Olney,2006)
The classical model thus assumes full employment, i.e. the actual output matches the potential output of the economy. Since prices are flexible, an increase in the supply of labour will lead to a deficit in the demand, as a result some workers will become unemployed, and some of the unemployed will offer their labour at a lower wage in an attempt to secure employment. As a result, those employed will also lower their wages causing the wage to decline relative to price level P, and real wage to fall. Due to the law of diminishing returns of marginal product of labour, as real wage falls, firms wishing to maximize their profit will employ more workers leading to an automatic adjustment of the labour market which is once again at equilibrium. In the case of demand exceeding supply, firms will offer higher wages to attract workers which will cause the real wage to rise. As a result other firms will reduce their labour such that the demand equals the supply again, and the labour market is at equilibrium. Thus real wage, in the classical model ,its movement is independent of the direction of growth of economy and is thus said to be acyclical. (Delong and Olney,2006; Mankiw, 2003)
Though few empirical studies support the theory that wages are acyclical, most critics pointed out that many wages and prices are not flexible and it is this inflexibility that explains both the existence of unemployment and the non-neutrality of money (Mankiw,2003) . Gamber and Joutz(2001) in their paper ‘Real wages over the business cycle’ studied the movement of real wage with respect to labour supply,demand ,aggregate demand and oil prices and concluded that increases in oil prices and reduced hours had little impact on the real wage thus making real wage acyclical. This could be true of the data studied, however many researchers including Solon et al (1994) have questioned evidence that claimed real wage to be acyclical, saying that a compositional bias tends to mask the true cyclical behaviour of a particular group’s real wage.
The Keynesian Model
While the classical model is only appropriate when wages and prices are flexible, it provides a simplified...