The Determination of Real Wages in the Long Run and its Changes in the Short Run –Evidence from Israel: 1968-1998

In this paper we study the determination of real wages in Israel for the long and short run during 1968-98. This period serves as a uniquely rich macro-economic laboratory as the Israeli economy went from hyper-inflation to low inflation, liberalization of the economy, decline of the powerful national trade union, massive immigration, influx of foreign workers and finally a high-tech led economic growth. We employ a simple Neo Classical framework in which long run real wages are determined according to labor productivity. This allows for a clear dichotomy between the long run and short-run. The long run is estimated using co-integration techniques whereas the short-run real-wage dynamic equations are linked to the long-run relationship via an error-correction term. The results of our study relate to important debates in the macroeconomic analysis of labor markets: Despite many competing theories based on market imperfections and complex institutions, we provide empirical support to the Blanchard and Katz (1997) approach and can not refute the simple neo-classical framework and find that in the long-run real wages are cointegrated with unit elasticity with labor productivity. In the short run we find, on the one hand, rising importance of market forces and evidence of nominal contracting with rational expectations such that real wages are affected only by unexpected inflation. On the other hand, unemployment benefits have increasingly produced real wages rigidities. These rigidities may in fact outweigh the short-term effect of the decline of the Histadrut- the national trade union.