The reason we worry about recessions is mostly involuntary unemployment. Because recessions cause employment fluctuations, and this affects the entire economy. But, why do recessions cause employment fluctuations? Indeed, this question is one of the most important questions at the heart of macroeconomics, and it shows us why nominal variables and wage stickiness is so important in recessions.

A useful way to distinguish shocks that affect the economy is to classify them as nominal and real shocks. Real shocks include the natural employment rate, technology shocks, taxes, and similar types of variables. Real shocks are particularly important when prices and wages are relatively flexible. If we lived in a world where all wages are perfectly flexible, nominal variables would be almost unimportant in this sense, and real variables would be enough to explain business cycles. Alas, that’s not the case, and it’s exactly what makes sticky wages the key problem.

The diagram below is from Scott Sumner’s new book, The Money Illusion.^[1]Sumner, S. (2021). The Money Illusion: Market monetarism, the Great recession, and the Future of Monetary Policy. p. 29. The University of Chicago Press. I like to think about business cycles and macroeconomics with this diagram. Because it helps us better understand why changes in nominal variables have real effects.

Money is neutral in the long run but strongly non-neutral in the short run, so monetary shocks affect real wages, output, employment in the short run.^[2]Sumner, S. (2021, September 29). Money neutrality, super-neutrality, and non-neutrality. Retrieved October 11, 2021, from https://www.econlib.org/money-neutrality-super-neutrality-and-non-neutrality. Therefore we can talk about the real effects of a change in nominal variables in the short run. However, it’s a little more difficult to explain why a change in nominal variables has real effects. I’ll show you that it’s mostly because of sticky wages. In my opinion, sticky wages are key to understanding business cycles and macroeconomics overall. But Kursad, why? Note that the recessions are caused by sharp declines in NGDP growth. Nevertheless, this itself does not explain why changes in the NGDP growth rate are so important, or why and how it relates to sticky wages. To understand the importance of NGDP shocks, we need to examine the nominal variables; and to understand that, we need to look at sticky wages closely. When economists talk about wage stickiness, what they usually mean is nominal wage stickiness. Because nominal wages are slow to adjust, this affects employment when the economy suffers a shock.

I will first explain why sticky wages matter, then explain why I prefer to focus on sticky wages rather than sticky prices.

Let’s start with a small-scale example to see how sticky wages work. Assume that the demand for refrigerators is unit elastic. For some reason, people are willing to spend more money on refrigerators than in previous years. This shifts the demand curve to the right, but that does not necessarily increase the number of refrigerators sold. In the case of full employment, this only causes wages and employment to rise, and refrigerator manufacturers simply increase the price per unit of the refrigerator. Nevertheless, if NGDP growth rates are low, wages will react to it, and we expect them to be highly sticky. In such a case, refrigerator manufacturers will likely respond to the change in demand by selling more refrigerators. Sticky wages aren’t the only reason for that, but it’s one of the most important reasons.

The evidence that wages are sticky in the short run is so obvious that I’ll take it as given. Instead, let’s look at a few ways to think about sticky wages. The conventional method of thinking about sticky wages is W/P. I think this works well in certain circumstances and not in others. For example, W/P will work well if the refrigerator industry is perfectly competitive. The MC curve shifts upward less than the demand curve, and output increases, so prices will increase, and W/P will fall. This would be a classic sticky wages scenario that leads to countercyclical real wages. But in a monopolistic competitive industry, for example, W/P will not work that well. A scenario in which neither wages nor prices will increase is likely, or both may increase very slightly and at similar rates. In such a case, W/P would be roughly the same, making it very difficult to explain business cycles in terms of W/P.

I think W/NGDP is much more useful than W/P. Nominal hourly wages are sticky, so it’s natural to expect hours worked to fall when nominal spending falls. W/P and W/NGDP are actually unrelated phenomena. Both stickinesses exist, but the key macroeconomic problem is nominal wage stickiness. On the other hand, microfoundations won’t help you beyond this point. The key is aggregate wage stickiness; it would be misleading to think about specific industries or firms. Suppose Saber Steel laid off a large number of workers in a recession. Saber Steel would have done this not because wages were sticky in the steel manufacturing industry but because wages were sticky in other markets or industries. Because wages outside of the steel industry are sticky, a reduction in total labor compensation leads to fewer hours worked. People or firms will buy less steel during a recession, but many everyday purchases will remain roughly the same. Thus, in a recession, for example, Burger King employees or cashiers are less likely to lose their jobs, while steelworkers are more likely to lose their jobs.

So far so good, but even if we agree that wage stickiness is matters and W/NGDP is more useful than W/P, why should we focus on wage stickiness and not price stickiness?

Basil Halperin argues here that it was a big mistake to switch from models of wage stickiness to models of price stickiness:^[3]Halperin, B. (2021, June 16). It was a mistake to switch to sticky price models from Sticky Wage Models. Basil Halperin. Retrieved October 11, 2021, from … Continue reading

The history of thought here and how it has changed over time is interesting on its own, but it also suggests a natural conclusion: if you think of involuntary unemployment as being at the heart of recessions, you should start from a sticky wage framework, not a sticky price framework. The original empirical and conceptual critiques of such a framework were misguided.

The debate over wage vs. price stickiness first caught my attention almost five years ago. Although I thought price stickiness was quite important back in those days, I have to admit that I didn’t care much about wage stickiness(but I was a 15-year-old teenager, so it can be forgiven). But after reading the article by Scott Sumner and Steve Silver, my views started to change. Silver and Sumner found in their study that wages are cyclical when the economy is hit by supply shocks, and highly countercyclical when hit by demand shocks.^[4]Sumner, S., & Silver, S. (1989). Real Wages, Employment, and the Phillips Curve. Journal of Political Economy, 97(3), 706–720. http://www.jstor.org/stable/1830462.

As I said, I didn’t care about wage stickiness back then. But at some point, I began to question whether inflation was a good variable for our models. A huge part of CPI is rent equivalent, so how can our models explain fluctuations in employment in this way? While there are more issues with the CPI, this was not the main problem that concerned me. NGDP is more of a “real” thing; It’s not just the sum of RGDP and inflation, it has real effects.

Let’s start with a simple question. In the long run, do wages track NGDP/person or inflation? If you think the answer is the latter, you cannot explain the relationship between rising wages and (relatively) low inflation. Despite having a similar inflation rate to the US, China has rapid nominal wage growth. NGDP/person growth drives up wages. And that’s exactly where this problem becomes different from the rest of the economics. We know that NGDP fluctuations are erratic, and nominal wages are slow to adjust; that’s why W/NGDP becomes countercyclical.

Mary Daly and Bart Hobijn created a labor market mathematical model in their work. The assumption lay on the model is that a given fraction of workers are resistant to wage cuts each year. The model also shows that the frequency of zero wage changes is highly correlated with the unemployment rate. Moreover, it explains why the recovery from the Great Recession has been slow. Daly and Hobijn found that productivity growth has the same effect as inflation in the labor market. I think NGDP growth is better than inflation in terms of the benefits of inflation. Here is another reason to prefer W/NGDP as NGDP growth is correlated with productivity growth+inflation.^[5]Daly, Mary C, and Bart Hobijn. 2013. “Downward Nominal Wage Rigidities Bend the Phillips Curve,” Federal Reserve Bank of San Francisco Working Paper 2013-08. Available at … Continue reading

Indeed, one of the strongest arguments is the gradual weakening of the relationship between inflation and employment. The Phillips Curve has many weaknesses in this regard and it often misleads economists, as we saw the most recent example in 2019. In contrast, as Joey Politano shows, the Phillips Curve is especially strong from the private sector wages perspective because employment is more associated with wage growth than inflation.

So, what’s my solution? Going back to the basic models such as AS/AD, because it’s much simpler and more useful. Let’s go back to what we were concerned with in the first place, unemployment. The AS/AD model was developed to explain fluctuations in employment. So the first thing we’ll look at is the labor market. And everything becomes clearer when we look at it. Hours worked move in the same direction as NGDP.^[6] Sumner, S. (2021). The Money Illusion: Market monetarism, the Great recession, and the Future of Monetary Policy. p. 151-154. The University of Chicago Press.

To summarize, 1) recessions and employment fluctuations are highly correlated, 2) nominal shocks have real effects, 3) hourly wages closely follow NGDP/person, 4) when the economy is hit by a negative nominal shock W/NGDP becomes highly countercyclical because nominal wages are sticky 5) W/NGDP is especially useful in explaining employment fluctuations, hence the recessions.^[7]Sumner, S. (2019, January 20). Are recessions about employment?. Retrieved October 3, 2021, from https://www.themoneyillusion.com/are-recessions-about-employment.

All of this may not lead us to NGDP targeting. A framework like GLI targeting is also possible, which is extremely attractive and will stabilize employment fluctuations similarly.^[8]Amarnath, S. (2019, May 18). Floor It! Fixing the Fed’s Framework With Paychecks, Not Prices. Retrieved September 23, 2021, from … Continue reading But from a W/NGDP perspective, regardless of policy implication, it’s clear that sticky wages almost always better explain fluctuations in employment.