Real Wages over the Business Cycle: A Band Spectrum Approach

Abstract

This paper presents new evidence on the cyclical relationship between real wages and aggregate employment. As is well known, models that attribute fluctuations in output to movements in aggregate demand and retain the assumption of flexible product prices (the ADPF hypothesis) imply countercyclical real wage movements as employment adjusts along a downward sloping aggregate demand for labor schedule. In contrast, real business cycle theories [10; 15; 13] suggest procyclical movements as workers substitute work for leisure along dynamic labor supply schedules. The empirical evidence on these propositions remains mixed. Some influential studies report a negative relationship [4; 5; 25;], others report a positive relationship [2; 12; 18] and Geary and Kennan (GK 7] to identify the purely business cycle correlation and distinguish it from correlations at very high and very low frequencies. The frequency domain decomposition provides a simple framework for reconciling the conflicting conclusions of previous studies and for focusing attention on the business cycle relationship. I show that the highly significant (positive or negative) correlations reported in previous studies are attributable to variations at frequencies far too high or far too low to be associated with the business cycle. The true business cycle relationship is quite different from that revealed by simple regressions of real wages on employment. I find a weak but statistically significant, negative relationship over business cycle frequencies for the post-war U.S. data when wages are deflated by the Producer Price Index (PPI). The negative relationship is particularly strong over the subperiod 1947-70 but becomes weak and insignificant over the last sixteen years 1971-86. This finding is consistent with the widely held belief that in the former period cyclical movements in employment were determined by changes in aggregate demand while real shocks dominated in the 1970s. However, when wages are deflated by the Consumer Price Index (CPI), the business cycle relationship is weak and not statistically significant over both subperiods. These results contrast sharply with those of previous studies that do not isolate business cycle components.

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