Wage and Price Dynamics in Canada

This paper examines wage and price dynamics in Canada with a view towards testing the implications of a wage-price dynamics, according to which unit labour costs are determined by a wage Phillips curve while prices are set as a markup over unit labour costs. This model is compared to an alternative model in which excess demand conditions influence prices directly, rather than indirectly through a wage Phillips curve. The empirical results indicate that, contrary to the standard model, Granger-causality runs from the rate of change of prices to the rate of change of (productivity-adjusted) wages, and not vice versa. Moreover, excess demand influences prices directly, rather than only indirectly through wages as the strong form of the standard model would predict. There is evidence that prices and unit labour costs are cointegrated, as theory would predict. We find that price adjustment is well described by an aggregate supply curve in price-output space, that is, a price Phillips curve. Wage adjustment can be described by an error-correction model in which wages adjust to clear disequilibria between the levels of the actual and equilibrium wage.