Testing Malta’s wage flexibility : a Johansen cointegration approach

Abstract

As a member of the EMU, Malta has no monetary independence, several fiscal constraints and a fixed exchange rate mechanism. These factors prohibit the economy from adjusting “easily” back to equilibrium following a deviation caused by an exogenous shock. This highlights the importance of alternative adjustment mechanisms, and wage flexibility provides one option. Measuring Malta’s degree of wage flexibility in the short-run and long-run is the primary goal of this dissertation.

This is done via a VECM model comprising real wages, unemployment, labour productivity and union density. Wage flexibility is captured by the coefficient on unemployment variable. Findings show that, on aggregate, the domestic labour market suffers from wage rigidities (unemployment coefficient of 0.26) and lack of equilibrium adjustment following a deviation. Moreover, labour productivity and union density are found to have a strong predictive coefficient (0.76 and 0.61, respectively) with regards to wage dynamics in the long-run. Since that the contextual analysis hints at strong domestic union density with high levels of collective agreements in the public sector, a private sector-restricted model is then estimated by extracting all public sector characteristics from the unrestricted model. The private-sector model shows evidence of wage flexibility (unemployment coefficient of -0.63) and a degree of adjustment implied by the error-correction term. Notably, in the restricted model union density is found to be statistically insignificant. These findings suggest that the inflexibility of wages in Malta is potentially caused by the high degree of unionization and collective agreements within the public sector. Policy recommendations suggest the introduction of flexibility in public sector collective agreements as well as further shifts towards indirect taxation.