The cyclicality of real wages allows us to differentiate between competing theories of the labor market. However, there has been empirical evidence put forth both for and against real wages exhibiting procyclical behavior. In this paper we provide new evidence on the cyclicality of real wages using longitudinal microdata in conjunction with a new econometric approach, that of a dynamic factor model. The dynamic factor model searches directly for the largest common cycle in wage data, alleviating the problem of defining the cycle as any particular macroeconomic variable. The use of individual level micro data allows us to determine whether the cyclicality of wages is specific to a certain subset of individuals, which alleviates the problem of composition bias.
Our main objective is to investigate whether real wages comove over the business cycle, and whether and in what extent their dynamic properties are consistent with the predictions of a Walrasian or an implicit contracts model. The factor model also allows us to disentangle the cyclical properties of wages for skilled (college) and unskilled (no college) workers. To do so, we employ a dynamic latent factor model in which real wages respond to common as well as skill&specific factors.
Beaudry and DiNardo (1991) show that adding appropriate lagged values of the unemployment rate (cyclical indicator) in a wage equation reduces substantially the degree of wage cyclicality. This raises an issue, not only about the choice of the cyclical indicator but also about the structure of the relationship between real wages and the cyclical indicator imposed by the econometrician. We postulate that if real wages comove with the business cycle then this must be reflected on a common, and possibly unobserved, factor.
Specifically, our dynamic factor model is motivated by the fact that if real wages exhibit a systematic relationship with the business cycle, then there should be a common factor which drives the movement of real wages in the same direction and accounts for a large portion of their variability. In addition, if the cyclical properties of real wages for skilled and unskilled workers are not alike, then there should exist skill specific factors characterized by distinct dynamics.
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On The Cyclicality of Real Wages and Wage Differentials
