Causal relationship between prices and wages: VECM analysis for Germany

The literature on causality as well as the empirical evidence clearly shows that there are two opposing groups of economists, who support different hypotheses with respect to the flow of causality in the price-wage causal relationship. The first group argues that causality runs from wages to prices, whereas the second argues that effect flows from prices to wages. Nonetheless, there is at least some consensus that researcher’s conclusions may be contingent on the type of data employed, applied econometric model, or even that the relationship may vary through economic cycles. This paper empirically examines the price-wage causal relationship in Germany, by using OLS and VECM analysis, and it also provides robust evidence in support of a long-run unilateral causal relationship between prices and wages, running from wages to prices. In contrast, the evidence suggests that there is no statistically significant short-run relationship between prices and wages. Prior to designing and estimating the econometric model we have performed stationarity tests for the employed price, wage and productivity variables. Additionally, we have also specified the model taking into account the lag order as well as the rank of co-integration for the co-integrated variables. Furthermore, we have also applied respective restrictions on the parameters of the estimated VECM. The evidence resulting from model robustness checks indicates that results are statistically robust. Although far from closing the issue of causality between prices and wages, this paper at least provides solid evidence for the case of Germany.