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Wage Dynamics: Reconciling Theory and Evidence

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  • Olivier Jean Blanchard
  • Lawrence Katz

Abstract

U.S. macroeconomic evidence shows a negative relation between the rate of change of wages and unemployment. In contrast, most theories of wage determination imply a negative relation between the level of wages and unemployment. In this paper, we ask whether one can reconcile the empirical evidence with theoretical wage relations. We reach three main conclusions. First, we derive the condition under which the two can indeed be reconciled. We show the constraints that such a condition imposes on the determinants of workers' reservation wages as well as the relative importance of workers' outside options as opposed to match specific productivity in wage determination. Second, in the light of this condition, we reinterpret the presence of an "error correction" term in macroeconomic wage relations for most European economies but not in the United States. Third, we show that whether this condition holds or not has important implications for the effects of a number of variables -- from real interest rates to oil prices to payroll taxes -- on the natural rate of unemployment.

Suggested Citation

  • Olivier Jean Blanchard & Lawrence Katz, 1999. "Wage Dynamics: Reconciling Theory and Evidence," NBER Working Papers 6924, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:6924
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    More about this item

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • J64 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Unemployment: Models, Duration, Incidence, and Job Search

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