ECO $215$ Macroeconomics Case Study

U$.$S$.$ Output Gaps and Wage Flexibility

Let$$s look at estimates of actual and potential GDP$.$ PowerPoint Slide $22$ measures actual GDP minus potential

GDP as a percentage of potential GDP for the United States. When actual output exceeds potential output, the

output gap is positive and the economy has an expansionary gap. For example, actual output in $2000$ was $1\mathrm{.}9$

percent above potential output, amounting to an expansionary gap of about $$180$ billion $($in $2000$ dollars$).$

When actual output falls short of potential output, the output gap is negative and the economy suffers a

contractionary gap. For example, actual output in $2003$ was $1\mathrm{.}5$ percent below potential output, amounting to a

contractionary gap of about $$170$ billion $($in $2000$ dollars$).$ Note that the economy need not be in recession for

actual output to fall short of potential output. For example, from $1992$ to $1998,$ and from $2001$ to $2004,$ the

economy expanded, yet actual output was below potential output. As long as unemployment exceeds its

natural rate, the economy suffers a contractionary gap.

Employers and employees clearly would have been better off if these contractionary gaps had been reduced

or eliminated. After all, more workers would have jobs to produce more goods and services, thereby increasing

the nation$$s standard of living. If workers and employers fail to reach an agreement that seems possible and

that all would prefer, then they have failed to coordinate in some way. Contractionary gaps can thus be viewed

as resulting from a coordination failure.

If employers and workers can increase output and employment by agreeing to lower nominal wages, why

doesn$$t such an agreement occur? As we have already seen, some workers are operating under long$-$term

contracts, so wages aren$$t very flexible, particularly in the downward direction. But if long$-$term contracts are a

problem, why not negotiate shorter ones? First, negotiating contracts is costly and time$-$consuming $($for

example, airline worker contracts take an average of $1\mathrm{.}3$ years to negotiate$).$ Longer contracts reduce the

frequency, and thus reduce the average annual cost, of negotiations. Second, long$-$term contracts reduce the

frequency of strikes, lockouts, and other settlement disputes. Thus, both workers and employers gain from

longer contracts, even though such contracts make wages more sticky and contractionary gaps more likely to

linger.

When demand is slack, why do employers lay off workers rather than cut nominal wages? Yale economist

Truman Bewley interviewed over $300$ managers, union officials, and employment recruiters and concluded

that resistance to pay cuts comes, not from workers or unions, but from employers. Employers think pay cuts

damage worker morale more than layoffs do$.$ By lowering morale, pay cuts increase labor turnover and reduce

productivity. In contrast, the damage from layoffs is brief and limited because laid off workers are soon gone

and cannot disrupt the workplace. What$$s more, even during the sharpest of recessions, more than nine in ten

workers still keep their jobs $($or soon find other jobs$),$ so most workers have little incentive to support a wage

cut to maintain employment.

Another reason workers may be reluctant to accept lower nominal wages is unemployment benefits. When a

worker is laid off, the incentive to accept a lower wage is reduced by the prospect of unemployment benefits.

The greater these benefits and the longer their duration, the less the pressure to accept a lower wage. For

example, in the latter part of the $1920$s$,$ unemployment benefits nearly tripled in Great Britain and eligibility

requirements were loosened. Despite record high unemployment during the Great Depression, money wages in

Great Britain remained unchanged during the period. For some people, unemployment benefits had become a

viable alternative to accepting a lower wage.

SOURCES: Truman Bewley, Why Wages Don$$t Fall During a Recession $($Cambridge$,$ Mass.: Harvard University Press, $2000)$;

Andrew von Nordenflycht, $$Labor Contract Negotiations in the Airline Industry,$$ Monthly Labor Review $($July $2003)$: $1828$; Laurence

Ball and David Romer, $$Sticky Prices and Coordination Failures,$$ American Economic Review $81($June $1991)$: $539552$; Daniel

Benjamin and Levis Kochin, $$Searching for an Explanation of Unemployment in Interwar Britain,$$ Journal of Political Economy $87$

$($June $1979)$: $441470$; Greg Ip$,$Fed$$s Moscow, Potential Growth Has Slowed,$$ Wall Street Journal, $19$ July $2007$; and Survey of

Current Business $87($July $2007).$

$.($CaseStudy: U$.$S$.$ Output Gaps and Wage Flexibility$)$ Unemployment is costly to employers, employees, and

the economy as a whole. What are some explanations for the coordination failures that prevent workers

and employers from reaching agreements?