why_canada_inflation_target

2 downward nominal wage rigidity some analysts

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Unformatted text preview: st of living.2 Downward nominal wage rigidity Some analysts believe that there is a psychological ‘floor’ to nominal (money) wages, such that wages are unlikely to decline even when there is considerable slack in the labour market. So they argue that a positive rate of inflation—preferably higher than 2 per cent—is needed to “grease the wheels” of the economy and encourage workers in struggling industries to accept a cut in “real” (inflation-adjusted) wages, rather than lose their jobs.3 While there is evidence of limited downward wage rigidity in Canada, this does not appear to have prevented labour market adjustment and to have raised the unemployment rate. 2 This does not necessarily mean that observed prices would be declining, but that they would be increasing less rapidly than the improvement in quality. So, this situation would not qualify as “deflation,” which is a persistent decline in prices caused by a sharp contraction in spending. 3 This essentially says that workers can be fooled by higher inflation into accepting a cut in the purchasing power of their wages, but that they would resist a wage cut that results in a similar reduction of purchasing power under low inflation. Experience with the high inflation of the 1970s and 1980s shows, however, that Canadians soon figured out that accepting a wage increase of 2 per cent when inflation was 4 per cent really meant a cut of 2 per cent in their purchasing power. The question is why would they not be able to figure out just as easily that a wage cut of 2 per cent with zero inflation amounts to the same thing? © Bank of Canada 2012 B A C K G R O Overall, the measurement error in the CPI and downward wage rigidities would not, by themselves, provide a strong argument against an inflation target lower than 2 per cent, although they could have implications for...
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