The effect of real wages and inflation on labour productivity in Malaysia

Abstract

This study examines the relationship between labour productivity, real wages and inflation in Malaysia using the bounds testing approach to cointegration and also the Granger causality test. The findings of this study suggest that inflation is negatively related to labour productivity. However, the effect of real wages on labour productivity is non-linear and the two have an inverted-U shape relationship. From a policy viewpoint, the Granger causality test shows that real wages Granger-cause labour productivity, but there is no evidence of reversal causation. Hence, the Malaysian dataset supports the claims by the efficiency wage theory. Moreover, we find that inflation and labour productivity in Malaysia have bilateral causality in the short- and the long-run.

Keywords:

• causality
• cointegration
• Malaysia
• productivity-wages-inflation

JEL Classifications:

• C22
• J24
• J30

Acknowledgements

The author would like to thank the anonymous reviewers for their insightful comments and suggestions. In addition, the author would also like to thank Kean Siang Ch’ng, Yong Kang Cheah and Chee Yin Yip for their contributions to this research. Any remaining flaws are the responsibility of the author and the usual disclaimer applies.

Notes

1. Efficiency wages theory is commonly used to justify the relationship between wages and labour productivity. According to the theory, increase in wages will stimulate labour productivity in several avenues. First, if workers receive higher wages, then the cost of losing their job becomes higher and this acts as an incentive for workers to work hard to avoid being fired (Shapiro and Stiglitz 1984). Second, if workers see an increase in wages as a gift, then workers will return this gift in the form of higher effort (Akerlof 1982). Apart from that, it is also plausible that an increase in wages will increase the cost of production and lower the profit. Consequently, firms might look for labour-augmenting technologies to improve productivity to restore the profit share (Kennedy 1964). Therefore, wages can also stimulate labour productivity via technology innovation. Thanks to the anonymous reviewer for suggesting the last point.

2. The concept of Granger causality is used to determine the ability of a time series in forecasting the variation of other time series. According to the concept, a time series ‘A’ is said to Granger-cause ‘B’ if and only if the past values of ‘A’ can help to predict the future value of ‘B’.

3. It is interesting to point out here that the negative part of the relationship between real wages and labour productivity (i.e. after the threshold) can also be due to the adverse effects of increases in unit labour cost on the firms’ supply curve. Thanks to the anonymous reviewer for suggesting this point.

4. Apart from that, one may argue that income tax may also affect the choice between working and leisure through its impact of wages. However, this is beyond the scope of this study, moreover some studies (e.g. Calmfors and Nymoen 1990; Rødseth and Nymoen 1999) found that income tax rates had no significant impact on wages. Therefore, either using after-tax wages or before-tax wages may not significantly affect the estimation results.