What effect do interest rates have on wages?

Readers Question: What effect do interest rates (either a rise, fall or steadying) have on both monetary and real wages? I think I’ve got my head around it, but I’m looking for a nicely explain summary (understanding that there are probably a million of contributing factors that can lead to a million outcomes!)

You are right, there is no direct link between interest rates and wages (either nominal or real), and there are thousands of possible combinations, which make it difficult to create simplistic answers. But, interest rates can have an impact on wages through affecting the rate of economic growth and inflation.

Interest rates and economic growth

Higher interest rates increase the cost of borrowing, so firms will cut back on investment and consumers will cut back on spending. This could lead to lower economic growth. With less demand and higher interest payments, firms may seek to cut wages (or increase wages at slower rate)

Furthermore, if higher interest rates do have the desired effect of reducing the rate of economic growth, then as well as lower economic growth, we should get lower inflation. This will be another factor leading to lower nominal wage growth.

Fall in AD

fall-ad-full-capacity

In this case, higher interest rates have reduced AD, leading to lower inflation and lower economic growth.

With lower inflation, we would expect to see lower nominal wages. But, also real wages (nominal – inflation) may be less affected.

  • Suppose inflation is running at 4% and nominal wage growth is running at 6%. (real wages = 2% growth)
  • Higher interest rates may reduce inflation to 2% and nominal wage growth falls to 4%. (but, real wage stay at 2%)

In this case, higher interest rates have reduced nominal wage growth, but left real wages unchanged.

However, if the higher interest rates caused a serious fall in real GDP, then there may be a significant fall in nominal wages, with only small fall in inflation. Therefore, in this case, higher interest rates could cause a fall in real wages.

fall-in-ad

If higher interest rates caused a fall in AD from AD3 to AD4, then there is a big fall in real GDP from Y3 to Y4. This could lead to a fall in both nominal and real wages.

Sticky wages downwards

There are so many other variables which make it difficult to predict.

If we get a fall in AD, firms may cut back on output. However, workers may resist nominal wage cuts – wages are often said to be ‘sticky downwards’. Therefore, wages may fall less than we might expect. It could lead to real wage unemployment.

Real wages in great recession

Graph showing monthly change in past 12 months real wage.

uk-real-wages-06-14

Usually, a cut in interest rates would be expected to increase aggregate demand (AD) – leading to higher economic growth and a rise in nominal wages.

inflation-base-rates-since-03

However, when interest rates were cut to 0.5% in 2009, growth was still very sluggish. We were in a liquidity trap – lower interest rates didn’t boost spending. Growth remained negative or weak. Due to flexible labour markets, nominal wage growth remained very low.

In the great recession, we also saw periods of cost-push inflation. Therefore, we often had periods of negative real wage growth. Inflation was higher than nominal wage growth.

So in this case, cutting interest rates didn’t cause a rise in nominal or real wages. In fact, this period led to negative real wages. But, this was because the nature of the recession was very severe. The normal relationship between interest rates and economic variables broke down.

There are numerous other possibilities we could look at.

Related

By on August 18th, 2017

4 thoughts on “What effect do interest rates have on wages?

  1. Hi shouldn’t higher interest rates be a signal that the economy is growing, and gdp growth is strong therefore leading to wage growth?

  2. Lukman say’s the effect of interests rates on economic Isa slight effect to fluctuate itself within the economic
    Boundaries, but growth domestic product is higher than the economic wages.thanks

Leave a Reply

Your email address will not be published. Required fields are marked *