By Mark Bils, Yongsung Chang and Sun-Bin Kim
We consider a matching model of employment with flexible wages for new hires, but sticky wages within matches. Unlike most models of sticky wages, we allow effort to respond if wages are too high or too low. In the Mortensen-Pissarides model, employment is not affected by wage stickiness in existing matches. But it is in our model. If wages of matched workers are stuck too high, firms require more effort, lowering the value of additional labor and reducing hiring. We find that effort’s response can greatly increase wage inertia.
Wages are sticky once one is hired, but flexible for new hires. In principle, this should make aggregate wage rather flexible, as the margin is the new hires. The paper shows this is not true if effort on existing job matches can respond: this undoes the hiring margin and aggregate wages are sticky.