RDP 9006: Wage Contracts, Sticky Prices and Exchange Rate Volatility: Evidence from Nine Industrial Countries 6. Summary and Conclusions

This paper has used a model of wage and price setting to examine two issues. Nominal wages and prices have been found to be universally sticky in that the growth rates of domestic and foreign wages converge only slowly, and prices cannot be changed without cost. This stickiness is associated with increased volatility in both nominal and real exchange rates. However, real wage rigidities – in the sense of wage indexation to inflation innovations at a rate greater than the optimum – have been found to exist in only two of the major industrial countries, Germany and the United Kingdom.

In those countries where real wage stickiness has not been found to exist, the requisite flexibility in real product wages has been made possible by the indexation of wages to consumer prices, with changes in nominal exchange rates driving a wedge between consumer and producer price inflation. These changes reinforce the volatility of nominal exchange rates brought about by the inflexibility of nominal wages and prices.

The policy implications of these results depend largely on whether excessive real exchange rate volatility has large welfare costs. If not, a reasonable second-best method of achieving real wage flexibility when faced with nominal wage and price stickiness will be via increased exchange rate flexibility. However, this solution is dependent on wage setters correctly identifying the optimal degree of wage indexation and acting accordingly. As the UK and German cases show, volatile real exchange rates could confound this identification. In such a case, the preferred policy prescription is to attack the nominal rigidities at their source.