Olivier Blanchard and Lawrence Katz, "Wage Dynamics: Reconciling Theory and Evidence"

Abstract

U.S. macroeconomic evidence shows a negative relationship between the rate of change of wages and unemployment. By contrast, most theories of wage determination imply a negative relationship between the level of wages and unemployment. In this paper we ask whether the empirical evidence can be reconciled with the theoretical wage relationships. We reach three main conclusions. First, we derive the condition under which the two can be reconciled. We show the constraints that such a condition imposes on the determinants of workers' reservation wages, as well as the conditions imposed in wage determination on the relative importance of workers' outside options vis-a-vis match-specific worker productivity. Second, we reinterpret the presence of the "error correction" term in macroeconomic wage relationships that is found in most European countries but not in the United States. Third, we show that whether this reconciliation condition holds has important implications for the effects of a number of variables--from real interest rates to oil prices to payroll taxes--on the natural rate of unemployment.

the article as a .pdf file


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