Discussion Paper Series 2006-E-28

Why are Nominal Wages Downwardly Rigid, but Less So in Japan?: An Explanation based on Behavioral Economics and Labor Market/Macroeconomic Differences

Sachiko Kuroda, Isamu Yamamoto

In this paper, we survey the theoretical and empirical literature to investigate why nominal wages can be downwardly rigid. Looking back from the 19th century until recently, we first examine the existence and extent of downward nominal wage rigidity (DNWR) for several countries. We find that (1) nominal wages were flexible in the 19th century and first half of the 20th century, but (2) nominal wages were downwardly rigid in almost all industrialized countries in the second half of the 20th century, although (3) the extent of DNWR varied from country to country. Next, we use a behavioral economics framework to explain the reasons for DNWR. We also explain why the existence and extent of DNWR varied between time periods and/or from country to country, focusing on differences in the labor market characteristics (such as labor mobility and employment protection legislation) and in the macroeconomic environment (such as economic growth and inflation), which can alter employees' and firms' perceptions toward nominal wage cuts.

Keywords: Downward nominal wage rigidity; Behavioral economics; Labor mobility; Employment protection legislation; Inflation rate; Indexation

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2006 Bank of Japan All Rights Reserved.

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