Wage differentials and real wage dynamics

Those who negotiate wages in companies are well aware of the difficulty of securing necessary wage adjustments, particularly when a downward adjustment in wages is required, in response to changes in the state of the macro economy. A key concern on the part of employees is how their wage stands relative to other groups of workers. The issue of labour market flexibility, and in particular wage flexibility, is of major concern to both individual companies and the national economy. If labour markets are flexible, the ability of companies and the economy to absorb demand and supply shocks is greatly enhanced and any adverse employment consequences arising from such shocks are likely to be reduced. This paper examines how a concern over relative wages on the part of employees affects the behaviour of real wage and employment levels in both the short run and the long run. The paper examines the pattern of wage adjustment that follows after an inflationary shock affects the economy and shows how the relative wage term can generate a divergence between short-run and long-run equilibrium, and in some cases over-adjustment of wage levels. The paper also suggests that a learning mechanism can explain the transition from short-run to long-run equilibrium.