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Reservation wages and the wage flexibility puzzle

Koenig, Felix, Manning, Alan ORCID: 0000-0002-7884-3580 and Petrongolo, Barbara (2016) Reservation wages and the wage flexibility puzzle. CEP Discussion Paper (1406). Centre for Economic Performance, London School of Economics and Political Science, London, UK.

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Abstract

Wages are only mildly cyclical, implying that shocks to labour demand have a larger short-run impact on unemployment rather than wages, at odds with the quantitative predictions of the canonical search model – even if wages are only occasionally renegotiated. We argue that one source of the wage flexibility puzzles is plausibly the model for the determination of reservation wages, and consider an alternative reservation wage model based on reference dependence in job search. This extension generates less cyclical reservation wages than the canonical model, as long as reference points are less cyclical than forward-looking components of reservation wages such as the arrival rate of job offers. We provide evidence that reservation wages significantly respond to backward looking reference points, as proxied by rents earned in previous jobs. In a model calibration we show that backward-looking reference dependence markedly reduces the predicted cyclicality of both wages and reservation wages and can reconcile theoretical predictions of the canonical model with the observed cyclicality of wages and reservation wages.

Item Type: Monograph (Discussion Paper)
Official URL: http://cep.lse.ac.uk/
Additional Information: © 2016 The Authors
Divisions: Economics
Centre for Economic Performance
Subjects: H Social Sciences > HD Industries. Land use. Labor
JEL classification: E - Macroeconomics and Monetary Economics > E2 - Consumption, Saving, Production, Employment, and Investment > E24 - Macroeconomics: Employment; Unemployment; Wages; Intergenerational Income Distribution (includes wage indexation)
E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E31 - Price Level; Inflation; Deflation
E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy Formation, Macroeconomic Aspects of Public Finance, Macroeconomic Policy, and General Outlook > E64 - Incomes Policy; Price Policy
Date Deposited: 09 May 2016 14:07
Last Modified: 26 Apr 2021 12:05
Funders: Economic and Social Research Council, Economic and Social Research Council
URI: http://eprints.lse.ac.uk/id/eprint/66417

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