The effects of wage volatility on growth

• Wage volatility does have significant effects on economic growth.
• There is a positive direct effect of wage volatility on growth.
• There is a negative indirect effect of volatility on growth through government size.
• This might explain why the effect of volatility on growth was ambiguous before.
• Ignoring the indirect channel through government size may mask true growth effects from volatility.

This paper shows that the volatility of wages has significant effects on a country’s rate of economic growth. Our theoretical framework suggests two distinct channels in which wage volatility affects growth: a positive direct way and a negative indirect way. The direct effect stems from precautionary savings, whereas the indirect effect works through the mediating role of government size. In the empirical part, we use a 3SLS approach to analyze a panel of 20 high-income OECD countries and find strong evidence for the existence of both effects. These results carry general and specific implications. In general, ignoring indirect effects operating through government size may mask the real net effects of volatility on growth, which could result in misleading conclusions. Specific to wage volatility, our results suggest that the net effect on economic growth depends on both government size and the wage premium from working in the private sector. Within our sample, we find evidence for both – countries for which wage volatility is beneficial to growth and others for which it is detrimental.