Labor force participation rates have been falling, wage rigidities have remained steadfast and the Phillips curve appears to be moving downwards and leftward, while the inflation expectations have been kept ultra- low by the policy instruments for a protracted period of time as interest rates are negative that furthers the cause of liquidity preference.

Even gold is not spared, which so far had been the harbinger of an unique one-directional upward movement for quite some time. This is a noteworthy shift propelled by a policy regime that has so far remained particularly rigid in creating and sustaining an inflation expectation, which is low.

It is time we examine the critical elements of labor force participation rates around the zero lower bound interest rates that have so far stymied all inflation expectations and have ushered a downward spiral.

Theoretical literature is agog with the suggestions of an ultra-low inflation rate as the optimal solution to welfare, but practically every Central Bank tries to create a positive inflation expectation regime to create a flow of jobs that makes easier adjustment to relative wages for the purpose of “greasing the wheels of the economy”, as Tobin et all in 1970 had written. But Akerlof, Dickens and Perry have also shown in 1996 that in the presence of downward nominal wage rigidity, a central bank which aims at an inflation rate which is too low will lead to higher steady state unemployment, thereby reducing welfare.

Central banks have in fact now attained the limits of ultra-low or negative inflation expectation thus making the employment situation rather uncertain as wage rigidities is one single largest contributor towards making labor force participation rates dwindle for the worse.

On closer inspection of the downward normal or real wage rigidities many authors have pointed out to this phenomena which is that a worker in a ultra-low inflation scenario does not agree to the wage on offer if it is too low as he is under the pressing assumption of inflation not ready to pick up any time soon and his desire to set a different wage rate than what is on offer stems more from the fear of losing the ability to get a better rate if the low rate on offer is accepted. Further to this the rigidity to not accept a low rate at the zero lower bound is due to a heightened period of inaction where workers wait for rates to stabilize in the hope that they would get better; this period of inaction is much smaller in duration when the inflation expectations are higher.

More research to solve the individual and dispersed wage-setters dilemma is yet to establish the causal linkage of why the period of inaction should be longer when the inflation expectations are weak that may lead to eventual dropping out of the worker; in most cases the worker finally lands up in service sector jobs even when he is not enrolled as participating in the labor force, which is also a problem of polling and data gathering.

Workers only react to inflation adjusted wages or the real wages. It is not that high inflation causes low unemployment (as in Milton Friedman’s theory) as much as vice-versa: Low unemployment raises worker bargaining power, allowing them to successfully push for higher nominal wages. To protect profits, employers raise prices. So in a depressed economy when inflation expectations are negative, workers do not have bargaining power and the higher duration of inaction sets a downward spiral in wage and with further prolongation of this phenomenon the labor force participation rate falls.

Procyon Mukherjee

15th April 2013

Labor Force Participation Rates, Wage Rigidities And Inflation Expectation: Wage Setters Dilemma
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