Simon Wren-Lewis: Nominal wage rigidity in macro: an example of methodological failure:
I have two stock complaints about the dominance of the microfoundations approach in macro…. My first complaint is that too many economists follow what I call the microfoundations purist position: if it cannot be microfounded, it should not be in your model. Perhaps a better way of putting it is that they only model what they can microfound…. My second complaint is that the microfoundations used by macroeconomists is so out of date. Behavioural economics just does not get a look in. A good and very important example comes from the reluctance of firms to cut nominal wages…. The behavioural reasons for this are explored in detail in this book by Truman Bewley…. Both money illusion and the importance of workforce morale are now well accepted ideas in behavioural economics. Yet debates among macroeconomists about whether and why wages are sticky go on…. In most other areas of the discipline overwhelming evidence is now able to trump…. But not, it seems, in macro….
Many have argued that the failure of inflation to fall further in the recession is evidence that the output gap is not that large… [yet] the reluctance of workers or firms to cut nominal wages may mean that inflation could be much more sticky at very low levels, so the current behaviour of inflation is not inconsistent with a large output gap. Work by the IMF supports this idea. Yet this is hardly a new discovery, so why is macro having to rediscover these basic empirical truths?… How could the [European] Commission have been so foolish as to believe the natural rate [of unemployment in Spain] had risen from 10% to 27% in a few years? Might it be… they… inferred from the fact that nominal wages were not falling that therefore actual unemployment must be close to its natural rate?…
The influence of DSGE models in policy making institutions is strong and growing. The Bank of England’s core forecasting model (pdf) is a fairly basic DSGE construct, and as far as I can see its wage equation is a standard New Keynesian specification, with no non-linearity when wage inflation approaches zero…. Focusing on models where consistency with fairly simplistic microfoundations is all important, and consistency with empirical evidence is less of a concern, can distort the way macroeconomists think.