This is one way of doing it

The study, by pay analysts Incomes Data Services (IDS), shows pay rises have remained at 2.5 per cent on average in recent months.

It means workers are effectively suffering pay cuts because the amount of cash left in their pockets after paying their bills will be lower.

By contrast the Retail Prices Index, the measure of inflation traditionally used to set pay increases, stands at more than double that level at 5.3 per cent.

Leave aside all the macroeconomics for a bit and concentrate on the micro.

We do have structural unemployment: no one is saying that at the peak of the boom in 2006/7 everything was just tickety boo on the unemployment front.

A market not clearing is at least an indication that prices in that market are too high for the market to clear. Thus a possible solution is for prices to fall so that the market will clear.

If wages fall relative to other prices then labour is becoming cheaper and we can therefore epet more labour to be hired in the future.

Think of this as a mild version of what Greece, Portugal and Spain have to do: those internal devaluations.

With a bit of Keynes added. For as he pointed out people are most loathe to have cuts to their nominal wages, but will put up with quite a lot of cuts to their real wages through inflation.

It\’s not nice of course, it does mean lowering the level of living standards. But looked at this way it\’s a way of solving the unemployment problem.

4 thoughts on “This is one way of doing it”

  1. I have long suspected that exchange rates are out of kilter with actual productivity – that wages here should not be ten times wages in China – this is what the inevitable adjustment looks like.

    Tim adds: If you took that portion of the Chinese economy which is coastal manufacturing, you’re quite right. Productivity isn’t 10 x and so nor should wages be. But then wages aren’t 10 x either. More like 5 x (and less at PPP).

    But wages aren’t set at factory or firm level but at economy level. And yes, productivity in general, across the entire economy, is much higher in the UK and thus much higher general wages are justified.

  2. What’s the micro foundation that people are prepared to take cuts in real wages through inflation but nominal cuts?

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