Describe the main explanations for the downward rigidity of wages in the modern macroeconomy. Evaluate their probability of being correct and important.

Question

What will be an ideal response?

Answer 1

One reason is the existence of institutional factors such as minimum wage laws, labor union contracts, and government regulations that mandate certain wage rates. Although most of these restrictions exist, they only cover a very small portion of the U.S. labor force. A second explanation is the psychological resistance of most workers to a pay cut. Even if this were true, such a resistance surely existed before World War II when wage drops were quite common. Another explanation of wage rigidity is the reduction in the severity and duration of business cycles in the post-World War II U.S. economy. This means that businesses and labor may simply “wait out” short downturns in economic activity and not feel the necessity of cutting prices or wages to get sales and employment to increase. A final explanation is that it is hard for firms to identify good workers and, therefore, may be reluctant to cut wages because they fear losing their most productive and valuable workers to other firms. All of these explanations may contain some truth, but there is not strong agreement among economists as to the importance of any one factor.