People do not spend as much as before when their wage drops, and they spend more if they have higher wages. While this is intuitive and apparently well explained, everything is related to wage flows and to wage dynamics. We hold that we should account the stock as well, meaning the cumulative gap between current levels and past reference levels of income. Cumulative wage gap is a better predictor of inflation than output gap because it is observable and it refers to past consumption and price levels; while output gap is nonobservable and it makes conservative assumptions for the future. Past wages are the minimum potential wages in the mind of wage earners. We assume that people judge their consumption decisions based on the relation between their current wages and their past wages, adjusted for inflation. The cumulative real wage gap, instead of nominal wage, is the explanatory variable in our new Phillips Curve. The dependent variable is the inflation gap, which refers to the gap between inflation and the inflation target (or, in the absence of a target, an average value of inflation over a longer time-span). Inflation gap is a more relevant variable for policy makers than the inflation rate because it puts inflation in relation to a desired level. A negative inflation gap means more demand-side measures are needed. A positive inflation gap means that the risk of overshooting is already present and policy tightening is required.
We will test separately these two assumptions: the shape of the curve and the break in the slopes. In terms of methodology, the analysis covers the OECD countries over the period 19902017, except for the United States where the data covers the period 1989 – 2017. Data sources for wages and inflation are the OECD and the FRED databases (for US), annual data. The reason for this selection is the availability of long-time data series on wages at OECD (they are only available since 1990), while for US the FRED database allows us to start from a known peak year, which was 1989. We used the following date: the average annual wage in 2017 constant prices at 2017 USD PPPs, exchange rate (national currency units/US dollar) and inflation (CPI) – annual growth rate, from the OECD database, and the real median household income in the United States, 2017 CPI-U-RS adjusted dollars, from the FRED database. We transformed the average annual wage into local currency for ensuring comparability with the inflation rate, which reflects changes in local prices. Data sources for the inflation target of central banks are from the respective central banks’ websites. If a central bank targets a corridor rather than a level of the inflation rate, then the midpoint of the target band is considered. The year T0 is the peak year. We define a wage adjustment episode the adjustment in real wages that follows after the peak year.