Pecuniary externalities in economies with downward wage rigidity

Martin Wolf

We describe a pecuniary externality in economies with downward nominal wage rigidity that leads firms to hire too many workers in expansions, which leads to too much unemployment in recessions. The externality arises because of competitive behavior in the labor market. When firms hire more workers, they push up market wages for all firms. Firms internalize that with higher wages, it is more likely that they will be constrainedby downward nominal wage rigidity in the future themselves; however, they fail to internalize the negative effects over other firms. In the calibrated model, when compared to a benevolent planner who chooses labor allocations on behalf of firms, the externality raises the welfare cost of downward nominal wage rigidity by a factor of 10, as it makes the economy significantly more exposed to unemployment crises.

Department of Economics
No. of pages
Publication date
Austrian Fields of Science 2012
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