EuroEconomica, Vol 35, No 1 (2016)

The switch to near-rational wage-price setting behavior: the case of United Kingdom

Adriatik Hoxha


The overall consensus of empirical evidence on the wage and price relationship reveals that causal relationships are difficult to identify. Moreover, elements other than wages, prices and productivity have significant impact in determining the wage-price setting equilibrium. Application of partial correlation and VECM analysis in the wage-price causal relationship in UK over the period 2000:Q1–2014:Q4 implies that there is strong evidence of structural change in the relationship. The VECM analysis implies statistically robust long-run cointegration relationship and negates short-run causality in any direction. Remarkably, there has not been a switch from near-rational to fully rational behavior, but the opposite. Additionally, the estimated values of cointegration coefficients provide strong evidence in favor of hypothesis that the assumption of near-rational behavior in the wage-price relationship in UK is valid. Specifically, the wage setters have under-adjusted for inflation as probably in their view the costs of such behavior were low. Furthermore, it seems that wage and price setters have unconditionally accepted the rigor of monetary policy authorities and did not pursue a policy which raises inflation rate above the target rate of monetary authorities. Ultimately, this near-rational behavior can be accredited to the high degree of labor market flexibility in UK.


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