Each school of thought tries to explain why there is Phillips curve or reasons for wage stickiness, explanations of which are not mutually exclusive.
I. Imperfect Information – Market clearing:
Some economists tried to explain the Phillips curve in context of how market clears.
Robert Lucas through his rational expectations approach showed that wages are fully flexible but adjust slowly because expectations are temporarily wrong.
Milton Friedman and Edmund Phelps developed models in which when nominal wages increase as price increases, workers mistakenly believe that their real wages have increased. Therefore, they are willing to work more.
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Thus, in the short run, unless workers realize their mistake that an increase in nominal wage is merely a result of increase in price, an increase in nominal wage will lead to an increase in output and decrease in unemployment.
Thus, slow adjustment of wages arises from workers’ slow reaction or imperfect information about changes in prices.
II. Coordination Problems:
The coordination approach to the Phillips curve focuses less on wages and more on the process by which firms adjust their prices when demand changes. Assume, there is an increase in the money stock. According to Fisher, changes in money supply is directly proportional to the changes in the price level such that when money supply increases, price level also increases in the same proportion. Thus, Price will increase in the same proportion as the money supply while output will remain unchanged.
If only one firm increases the price while other firms do not increase the price, then that single firm will lose its business to the others. But if all firms raise their price together in the same proportion, they would immediately move to the new equilibrium. Since the firms cannot get together to coordinate their price increase, each firm raises the price slowly.
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Co-ordination problem explains why wages are sticky downwards, that is why wages do not fall immediately when aggregate demand falls. If one firm due to decrease in demand for goods cuts its wages, while other firms do not, then the workers will get annoyed and leave the firm. But if firms coordinate, they can cut wages together. Since there is no co-ordination, wages go down slowly.
III. Efficiency wages and costs of price change:
Efficiency wage theory states that the wages are means of motivating labour. The amount of effort (work) the workers make depends on how well the job is paying as compared to alternative jobs. Firms may pay wages above the market-clearing wage to ensure hard work from its employees and to hold on to their work.
Although this theory explains the problem of unemployment yet does not explain why nominal wage is slow to change. By combining stickiness with problems of coordinating, this theory can explain the cause of wage stickiness.