Nominal wages, or “money wages,” are pay rates unadjusted for inflation. In contrast, “real wages” are adjusted for inflation. When real wages increase, recipients can buy more with them. When nominal wages increase less than do price levels, recipients can buy less with them.
Classical economists believed that economic behavior is rational in the sense that it responds to real rather than nominal values. In labor markets, this implies that workers interpret a given decrease in real wages identically whether it was caused by a rise in inflation or by a fall in nominal wages. One of the key departures of John Maynard Keynes in his General Theory of Employment, Interest, and Money (1936) was that “a situation where labour stipulates (within limits) for a money-wage rather than a real wage, so far from being a mere possibility, is the normal case. Whilst workers will usually resist a reduction of money-wages, it is not their practice to withdraw their labour whenever there is a rise in the price of wage-goods” (p. 9). Nominal wages matter because nominal cuts typically occur in piecemeal fashion, which, in turn, alters any single group of workers’ relative wage position. Thus, resistance to nominal wage cuts is a defense of one’s relative wage position. If money wages could be lowered universally by the same percentage, Keynes’s analysis suggests that there would be no more resistance on the part of labor than to the effects of a general inflation.
Early evidence of the downward nominal wage rigidity, or “sticky wages,” was found in observed macroeconomic relationships. Increasing real wages during the Great Depression was attributed to falling prices combined with downward nominal wage rigidity. The post–World War II Phillips curve—the negative relationship between nominal wage changes and unemployment rates—was also explained by sticky wages, as was the non-neutrality of money supply, whereby money supply cuts caused recessions. Later studies have countered this “evidence” with alternative explanations—not based on nominal wages—that predict the same relationships.
Beginning in the 1980s, evidence of downward nominal wage rigidity has been sought in the time patterns of wages of individual workers within companies. This research has found many people with exactly zero nominal wage changes and very few whose nominal wages decrease, in contrast to no workers with exactly zero real wage changes and many whose real wages decrease. This holds true for low and moderate inflationary environments.
Different theoretical explanations of downward nominal wage rigidity assume different amounts of worker rationality. Many economists model nominal wage rigidities as rational responses to unanticipated shocks combined with imperfect information or costly wage changes. For instance, if workers can observe their own wage increases or decreases but not others’ wages and not general inflation levels, they may temporarily erroneously interpret a nominal wage cut as a negative signal (of the match quality or of the company’s health) rather than a response to an economy-wide decline. It may take time for firms to be certain that their economic situations warrant wage responses, particularly when information arrives intermittently. Both time and administrative costs may be required to both gather the relevant information and implement changes in nominal pay levels, leading to infrequent, staggered wage adjustments. Any of these factors can have major macroeconomic implications. Many theories predict these implications to last only for a short run, although some models imply pervasive stickiness.
Downward wage rigidities have also been attributed to efficiency wages—that is, paying higher than market-clearing wages to increase productivity or worker quality—or to insider-outsider theories—where insider workers have bargaining power within firms. However, both of these explanations generate real rather than nominal rigidities, unless coupled with misperceptions or costly adjustments.
An intermediate view assumes “near-rationality.” Humans have finite cognitive capacity and must edit out minor factors by using simple, unvarying rules of thumb. In environments of low inflation, individuals bear few costs if they assume that prices and nominal wage structures are constant. If many workers and/or firms behave in this way, however, it creates slowdowns that can persist.
Other psychologically based explanations emphasize that workers often infuse their nominal (money) wages with independent psychological meanings. Opinion surveys and experimental evidence have shown that many people’s self-esteem or sense of self-worth depends on the level and changes of their nominal wages, particularly in comparison to the nominal wages of others within their firm. Many workers believe it unfair if employers violate social norms by decreasing nominal wages, even in response to a weak labor market. Finally, individuals have been shown to place more weight on avoiding losses than achieving gains. In this context, decreases in nominal wages lower morale, which can lead to reduced productivity and/or turnover. Given this, rational employers are reluctant to lower nominal wages, preferring to let real wages fall as prices rise.
SEE ALSO Happiness; Inflation; Keynes, John Maynard; Money Illusion; Nominal Income; Relative Income Hypothesis; Wages
Akerlof, George A., William T. Dickens, and George L. Perry. 1996. Near-Rational Wage and Price Setting and the Long-Run Phillips Curve . Brookings Papers on Economic Activity 2000 (1): 1–60.
Bewley, Truman F. 1999. Why Wages Don’t Fall During a Recession. Cambridge, MA: Harvard University Press.
Keynes, John Maynard. 1936. The General Theory of Employment, Interest, and Money. London: Macmillan.
Mankiw, N. Gregory, and Ricardo Reis. 2006. Pervasive Stickiness. American Economic Review 96 (2): 164–169.