So you think a drop in Inflation will increase your Real Wage?

Since we’ve talked about how real wage is determined, I’m doing this short post to bust a common misconception.

It appears common sensical to believe that if inflation falls, the purchasing power of your wage i.e. your “real wage” will increase. So inflation seems to be the enemy. If inflation were lower, you’d be richer in real terms.

Not true. Let me explain.

Some basics first:

Real wage signifies the purchasing power of our nominal wage (w) or the amount of goods and services we can buy with our nominal wage. It is calculated as w/P where “P” is an appropriate wage deflator such as CPI inflation. CPI (Consumer Price Index) inflation for July 2016 was 6.46% (latest data). 

Now, remember from my post Market Structure: Classical Vs. Keynesian Assumption, that in a perfectly competitive market, the firm’s demand curve for labour is: 

w = P0 * MPL              (1)

Where w = nominal wage, P0 = price of the output, and MPL = Marginal Product of labour. 

Recall that the Marginal Product of labour (MPL) = the units of output produced by employing an additional unit of labour, keeping everything else constant. 

Rearranging (1), we get

w/P0 = MPL

This means that real wage (w/P0) is = the Marginal Product of labour. 

Now....

if there is inflation in the economy i.e. prices rise, then P0 will rise. But the MPL will still remain the same. This means that “w” will have to rise as well.

Lets assume the opposite i.e. prices fall. When prices fall --> P0 falls --> since MPL remains the constant, “w” falls as well. 

So here’s the thing......

Wages tend to move along with inflation, so that purchasing power remains the same (= the marginal product of labour). If inflation continues to drop, wage rise will tend to slow down as well. 

So even though inflation appears to be the enemy, it is not. Real wages can rise only if the productivity of labour (Marginal Product) rises. Else they remain stagnant.