Price Rigidities and the Effects of Wage Policy

Abstract

The paper analyzes the effects of wage policy intended to reduce unemployment under the assumption that prices do not automatically respond to lower wages. More precisely, it is assumed, that prices and nominal wages are not linked by equalizing marginal revenue and marginal costs, but that price adjustments come about via market entries which are indirectly triggered by a declining wage rate. It is shown, that in the case of only a weak price reaction a general nominal wage cut, although successful in the combat against unemployment, can be accompanied with undesirable side effects such as inefficiently high factor inputs, a lasting decrease in the real sum of salaries or even a decline in output. Furthermore, if overshooting in conjunction with market entries takes place, complex dynamics can occur. On the other hand, the optimistic scenarios in line with standard models of perfect or imperfect competition can be reproduced under the assumption, that the price adjustment is sufficiently strong.