Benjamin Schoefer on the Musical Chairs Model
Over the past decade, I’ve been advocating what I call the “musical chairs model” of the business cycle. This is from a 2013 blog post:
You don’t need DSGE models to understand business cycles, it’s basically just a game of musical chairs. Nominal wages are very sticky and NGDP is very volatile. So when NGDP falls there is less money to pay workers, and rather than taking nominal wage cuts you get lots of workers sitting on the floor—unemployment.
I propose a financial channel of wage rigidity. In recessions, rather than propping up marginal (new hires’) costs of labor, rigid average wages squeeze cash flows, forcing firms to cut hiring due to financial constraints. Indeed, empirical cash flows and profits would turn acyclical if wages were only moderately more procyclical. I study this channel in a search and matching model with financial constraints and rigid wages among incumbent workers, while new hires’ wages are flexible. Individually, each feature generates no amplification. By contrast, their interaction can account for much of the empirical labor market fluctuations—breaking the neutrality of incumbents’ wages for hiring, and showing that financial amplification of business cycles requires wage rigidity.
The paper (p. 34) also contained this interesting observation:
A testable prediction is that financially constrained firms’ labor demand elasticities are higher due to the cash flow effect, and that encompassing wage changes, for all workers, have larger effects than marginal wage changes. Saez, Schoefer, and Seim (2019) provide some evidence for this prediction, studying net-of-payroll-tax wage changes from a payroll tax change that targeted young workers (but ended up boosting employment for all, even ineligible, worker groups, especially in financially constrained firms).
When nominal GDP falls sharply, firms receive less revenue. Even if new hires are willing to take pay cuts, the sticky wages of existing workers cause firms to reduce employment, often closing down money-losing units within the firm, such as factories. A mixture of labor market norms and training costs prevent firms from immediately reopening these closed factories with new hires at a lower wage level.
Nominal wage stickiness really does exist, and cannot be brushed aside.