Costly Wage Cuts, Relative Wage Comparisons, and Unemployment Hysteresis

Marco Fongoni

No 2540, AMSE Working Papers from Aix-Marseille School of Economics, France

Abstract: This paper advances a theory of unemployment hysteresis—transitory shocks leave permanent effects—based on a model of endogenous path-dependent wage rigidity under incomplete employment contracts. Workers’ relative wage comparisons—incumbents’ aversion to wage cuts and new hires’ concern with pay inequality—imply wage increases are partially irreversible, generating path dependence and asymmetry in wage adjustments. During recessions, hiring wages fail to adjust fully downward, depressing job creation and producing hysteresis effects and large unemployment fluctuations. A quantitative assessment shows that these effects can be significant under plausible calibrations of the cost of wage cuts and the sensitivity of workers to relative wages. A 1% transitory shock can generate a permanent increase in unemployment of about 0.5% to 15%, with benchmark values around 1.5–5.5%. The paper concludes by discussing the implications of the theory for the effectiveness of monetary policy and the empirical research on hysteresis effects, suggesting promising directions for future research.

Keywords: incomplete contracts; wage rigidity; irreversibility; hysteresis; unemployment (search for similar items in EconPapers)
JEL-codes: E32 E52 E71 J23 J30 J60 (search for similar items in EconPapers)
Pages: 74 pages
Date: 2025-12
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Persistent link: https://EconPapers.repec.org/RePEc:aim:wpaimx:2540

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