JOURNAL OF ECONOMIC DEVELOPMENT 131 Volume 34, Number 2, December 2009 EFFICIENCY WAGES, INFLATION AND GROWTH HARILAOS MERTZANIS * Hellenic Capital Market Commission The efficiency wage hypothesis is introduced and a work effort function is specified in which labor productivity depends on the distribution of income between wages and profits and the general level of output. The function is then incorporated in a structuralist-Keynesian growth model in which investment decisions depend on income distribution, inflation and the level of output. A ‘conflict theory of inflation’ is then developed in which wage and price change depend on real income aspirations and the rate of employment. It is, then, shown that changes in income distribution exert a direct effect, via aggregate demand, and an indirect effect, via work effort, on output and inflation. The two separate effects may be complementary or contradictory. The direction and magnitude of the overall impact on inflation and growth depends on institutional factors, such as the specification of the effort function, the different savings propensities, the determinants of capital accumulation and the state of income distribution. Keywords: Efficiency Wages, Conflict Inflation, Growth JEL classification: E12, E24, E31 1. INTRODUCTION Inflation persistence, output volatility and sluggish labor market adjustment during the last decade have been an intensely investigated topic. One line of research focused on labor market institutions and wage rigidity. The latter were seen as an important source of relatively high unemployment in Europe (Jackman (1999)). Recent evidence suggests that unionization and collective bargaining coverage are positively related to real wage rigidity, and that differences in the degree of wage rigidity may partly explain differences in unemployment rates across countries (Dickens et al. (2006), Holden and Wulfsberg (2007)). Wage rigidity can impact not only on unemployment, but also on inflation dynamics. The findings of the Eurosystem Inflation Persistence Research Network conclude that wage rigidity can be a cause of price stickiness observed in the Euro area. Numerous * The author is grateful to an anonymous referee for very helpful comments and suggestions.