Stepping Off the Wage Escalator: The Effects of Wage Growth on Equilibrium Employment

Abstract

This paper emphasizes the role of wage growth in shaping work incentives. It provides an analytical framework for labor supply in the presence of a return to labor market experience and aggregate productivity growth. A key finding of the theory is that there is an interaction between these two forms of wage growth that explains why aggregate productivity growth can affect employment rates in steady state. The model thus speaks to an enduring puzzle in macroeconomics by uncovering a channel from the declines in trend aggregate wage growth that accompanied the productivity slowdown of the 1970s to persistent declines in employment. The paper also shows that the return to experience for high school dropouts has fallen substantially since the 1970s, which further contributes to the secular decline in employment rates. Taken together, the mechanisms identified in the paper can account for all of the increase in nonemployment among white male high school dropouts from 1968 to 2006. For all white males, it accounts for approximately one half of the increase in the aggregate nonemployment rate over the same period.