Wages and Economic Activity

Abstract

The role of wages in economic fluctuations is a rather fraught topic, having been the subject of bitter controversy for many years. Like most such arguments, the fundamental issue is how well a decentralised market economy works and, when it patently does not work in practice, whose fault it is. Our purpose in what follows is to discuss how the economy responds to various kinds of shocks from both the demand and the supply side and to highlight the role of wages in particular and the labour market in general. In order to do this we set up a very simple closed economy model and study its response to shocks. Specific topics on which we focus include nominal inertia, real and nominal wage movements, price setting behaviour and hysteresis.