Inderscience Publishers

The possible perverse effects of declining wages

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Central bankers fear deflation but this is incomprehensible within the standard AS/AD framework based on a real wealth effect. This framework is amended by introducing debt effects that reduce aggregate demand when prices fall, as emphasised long ago by Keynes, Kalecki and Fisher, thus showing that wage deflation may have perverse effects. An alternative model is then presented, based on markup pricing and non-decreasing returns, and incorporating the impact of income distribution on aggregate demand. The wealth and debt effects, as well as those of income redistribution, are then considered when wage and price deflation occurs. The purpose of the paper is to provide a pedagogical tool showing why deflation is being feared by economists operating in the real world and demonstrating why the downward flexibility of wages may have negative macroeconomic effects.

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