Relationship between nominal wage and price flexibility: Implications for monetary policy∗

The frequencies at which prices and wages are adjusted are key elements in workhorse models used for policy analysis. Yet, there is little evidence regarding the relationship between these two sources of nominal rigidities. Using large price and wage micro-datasets, this paper shows that the frequency of price adjustments is positively related to the frequency of wage changes across industries. By developing a multi-sector economy with heterogeneous wage and price stickiness, our estimates indicate that positive-related price and wage rigidities generate larger and more persistent real effects than models with no relationship or models in which all sectors reset prices and wages with the same average frequency. We calculate that, for an identical-firms model to replicate the real effects of the heterogeneous economy, it requires frequencies of price and wage changes to be set at three-quarters the average-frequency of price and wage changes. These results suggest two lessons for New Keynesian literature: first, we can abstract from ad-hoc mechanisms generating greater persistence in macro aggregates, such as indexation or habit formation, by incorporating price and wage heterogeneity; and second, we need to rethink the simplifying assumption that priceand wage-setting are independent processes as micro-evidence indicates otherwise. ∗We would like to thank Erwan Gautier, Roberto Pancrazi, Juan Carlos Gozzi, Roland Rathelot and Kevin Sheedy for their useful comments. This paper has greatly benefited from views received at the International-Macro Workshop at Warwick, as well as the Macro Workshop at Cardiff Business School. †Corresponding author at: University of Warwick, Department of Economics, Coventry CV4 7AL, UK. E-mail: [email protected]