Ebook A Partial Adjustment Model of Interrelated Prices and Wages with its Applications to Korea and Japan
One of the most controversial issues in the relations between wages and prices is whether inflation is caused by an increase in wages or an increase in wages is caused by an increase in the living costs due to inflation.
A series of statements by government authorities strongly supports the idea that the level of prices can be stabilized by suppressing an increase in wage rates. This idea is not novel. Standard economics admits that the wage is an important item in the production costs and that an increase in the wage rates causes an increase in costs which, in turn, causes an increase in the general price level. This process is known as the cost-push inflation.
If inflation of our real world is due to the cost-push process, then the suppression of an increase in the wage rates is certainly an effective device to cure inflation. But the relation between wages and inflation may be the other way round. According to the demand-pull theory of inflation, inflation is caused by an excess demand in general relative to the aggregate supply. If an excess demand causes inflation, inflation, in turn, increases the cost of living, which leads to an increase in the wage rates.
During the 1960s and 1970s, the Korean economy experienced high levels of inflation and high increses in the nominal wage rates. But the direction of causality has not been fully clarified. Those who want to suppress the wage increase tend to have relied on the theory of cost-push inflation, while those who want the higher wage rates tend to have relied on the theory of demand-pull theory of inflation. But neither side has a strong empirical ground for its arguments.
If we want to know whether wages lead prices or prices lead wages, then we need to clarify the mechanism of the wage-price interrelations. Intuitively, as well as theoretically, we should admit that both the theory of cost-push inflation and the theory of demand-pull inflation contain a bit of truth. We cannot deny any one of them a priori. Therefore our argument on the causality of wages and prices should be focused not on the direction but on the magnitude of its effect. In other words, we need to measure the magnitude empirically.
For the empirical magnitude of the effect, we need an econometric model that can explain the interrelations of wages and prices as well as the external effects of major exogenous variables. It seems that existing models of inflation are not sufficiently adequate for this purpose. Therefore, our first task is to develop a model that fits this purpose. The model is a partial adjustment model which is specifically familiar in the theory of investments.
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