This installment, below the fold, discusses real wage rates and employment. The previous installment was here.Real Wages and Employment

Perhaps the most widely-used theory of employment fluctuations is that they are caused by changes in real wage rates. In general, the thinking goes that if real wage rates rise, labor demand falls, and assuming that labor supply is highly elastic at the too-high real wage rate, this leads to unemployment.

Interestingly, there also are theories that employment declines because real wages are too low. One theory comes from the far left in Britain in the 1930’s. That is that when real wages are low, the distribution of income favors profits. Capitalists have a higher propensity to save than workers, and excess saving leads to reduced output and higher unemployment.

The other theory comes from the far right in the United States in the 1980’s. This theory says that labor supply is highly responsive to short-term changes in real wage rates. As a result, temporary adverse productivity shocks, which lower real wage rates, cause higher unemployment. This is perhaps the most common description of “real business cycle” theory, which focuses on shocks in the “real” or supply side of the economy rather than on shocks to the monetary or demand side of the economy.

Both of these theories of procyclical real wages have major empirical drawbacks. Profits are more procyclical than labor compensation, which is an inconvenient fact for the theory that recessions are caused by a redistribution toward profits. And the Great Depression, with its decade of high unemployment, is difficult to explain as a temporary reduction in labor supply.

Let us turn instead to the theory of countercyclical real wages. Often, this starts with a theory of sticky nominal wages. When the money supply rises sharply, prices rise faster than wages, causing the real wage to fall. As a result, the demand for labor rises. As long as the economy is below full employment, labor supply is highly elastic at this new real wage rate, so employment rises. For sharp decreases in the money supply, this entire process reverses.

The theory of countercyclical real wages is perhaps the most straightforward way to explain macroeconomic fluctuations. However, we will see that it suffers from both theoretical and empirical drawbacks. The theoretical problem is to explain why workers would be fooled into accepting low real wages when there is high inflation. The empirical problems include the fact that real wages have not been especially countercyclical in the United States since World War II as well as the fact that the sectors that bear the brunt of the business cycle–housing and durables goods production–are characterized more by inventory fluctuations than by real wage movements.

When there is high unemployment, it is almost certainly true that, all else equal, lower real wage rates would help to reduce unemployment. However, to concede that point is not to agree that the entire business cycle rests on countercyclical real wage rates. If a flood of refugees arrives, other things equal, the lower their wage rates the lower will be their unemployment rate. However, that is not an argument that high unemployment among a flood of refugees is entirely a problem of too-high real wage rates.