Is Downward Wage Flexibility the Primary Factor of Japan’s Prolonged Deflation?
By using both macro- and micro-level data, this paper investigates how wages and prices evolved during Japan’s lost two decades. We find that downward nominal wage rigidity was present in Japan until the late 1990s but disappeared after 1998 as annual wages became downwardly flexible. Moreover, nominal wage flexibility may have contributed to relatively low unemployment rates in Japan. Although macro-level movements in nominal wages and prices seemed to be synchronized, such synchronicity was not observed at the industry level. Therefore, wage deflation does not seem to be a primary factor of Japan’s prolonged deflation.
Most central banks are now targeting a positive inflation rate of a few percentage points. One of the reasons for not targeting a zero inflation rate is the downward rigidity of nominal wages, which could cause huge inefficiency in the resource allocation of the labor market (Akerlof et al. 1996). By creating an environment in which real wages can be adjusted, a positive inflation rate thereby serves as a “safety margin” against the risk of declining prices.