A fall in real wages during a recession ameliorates the decline in employment, whereas if wages are rigid, any transitory shock lead would lead to a jobless recovery, with a decline in employment, capital and consumption. This paper analyzes the effects of wage rigidity, on both labor market dynamics and unemployment volatility, by comparing two European economies, Spain and Latvia, with very different wage dynamics.
It uses a matching model with endogenous separation on 2004-2011 data to provide empirical evidence showing that the unemployment volatility is higher in rigid wage economies. It finds that in Spain, real mean wages remained high despite unemployment rising to over 20 percent. In contrast, Latvian wages were much more flexible than Spanish wages, decreasing by about 10 percent, and wage cuts affected 60 percent of jobs. The elasticity of (job) finding and separation rates due to productivity shocks was four times higher in Spain than in Latvia, and more persistent. The study also finds that workers’ flows, both into and out of unemployment, are far more responsive with respect to productivity shocks in a rigid wage economy. The separation rate plays a more important role than was previously documented in explaining the rise in unemployment during a recession.
Overall, findings support the notion that wage rigidity tends to amplify the effect of shocks, and generate higher volatility in workers’ flows and unemployment.