Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use the Shapiro-Stiglitz Efficiency Wage Model
Transcript
- Lucas: Luna, I want to talk about a piece of economic theory that central bankers actually use, even if they don't always say its name. The Shapiro-Stiglitz efficiency wage model. Luna: Okay, that's a mouthful. Remind me — this is the one about firms paying above the market-clearing wage to stop workers from slacking off? Lucas: Exactly. Carl Shapiro and Joseph Stiglitz published it in 1984, and it basically says that if firms can't perfectly monitor effort, they'll pay a wage premium. That premium makes workers value their job more, so they're less likely to shirk. The catch is, this creates involuntary unemployment even in equilibrium, because the wage is above the level where supply equals demand. Luna: Right, because if everyone got paid the market-clearing wage, workers would be indifferent between staying and leaving. The premium introduces a cost to getting fired. Lucas: That's the core insight. And the reason central banks care is that the model gives a structural explanation for why unemployment doesn't fall to zero even in a boom — and why wages can be sticky. Which feeds directly into how they think about the Phillips curve, the NAIRU, and ultimately, interest rate decisions. Luna: So when we hear about the NAIRU shifting — like, say, after the pandemic — this model is part of the toolkit for understanding why? Lucas: A big part. Let me give you a concrete example. In 2025, the Bank of England published a working paper titled 'Efficiency Wages and the Post-Pandemic Labour Market.' The authors used a variant of the Shapiro-Stiglitz model to explain why UK wage growth stayed elevated even as the labor market cooled. Their argument was that the pandemic increased the cost of shirking for certain sectors — or rather, changed the detection rate because of remote work — so firms had to raise the wage premium further. Luna: Interesting. So the model isn't just a textbook abstraction. They actually calibrated it with UK data. Lucas: They did. And what they found was that the efficiency wage channel could account for about 0.8 percentage points of the persistent wage stickiness in 2023 and 2024. That's not trivial when you're trying to bring inflation down to 2 percent. The paper argued that the NAIRU had temporarily risen by about half a percentage point because of this mechanism. Luna: So the model helps explain why the labor market looked so tight for so long, even after job openings started to fall. Firms were holding onto workers and paying them more to prevent turnover and shirking. Lucas: Exactly. And there's another dimension the Bank of England paper touched on: the composition of the workforce. The UK saw a particularly sharp drop in labor force participation among workers aged 50 to 64 after the pandemic. That group has a higher tendency to shirk — or rather, a lower cost of shirking because they're closer to retirement — so firms had to raise wages for younger workers to keep them from shirking, which further pushed up aggregate wage growth. Luna: That's a really specific channel. So the model says that if older workers leave, the remaining workers have more bargaining power, and firms use efficiency wages to keep them productive. Lucas: Right. And the central bank's response depends on whether they view this as temporary or structural. If the efficiency wage premium is sticky because of a permanent shift in monitoring costs — say, hybrid work is here to stay — then the NAIRU might be permanently higher. That would mean the central bank has to keep rates higher for longer to avoid overheating the labor market. Luna: But is there a risk that central banks overreact? If they see wage growth and assume it's driven by efficiency wages, they might tighten too much, when actually the wage growth is just a temporary adjustment. Lucas: That's the calibration problem. The model itself doesn't tell you the size of the premium. You have to estimate it from data, and those estimates are noisy. The Bank of England paper estimated that the efficiency wage premium in the UK rose by about 15 percent relative to 2019. But that's just one model with one set of assumptions. Other models might give a different number. Luna: So central banks use the model as a framework, not a rule. It helps them interpret the data, but they don't plug it into a Taylor rule directly. Lucas: Exactly. And this is where the model connects to the broader monetary policy conversation. The Shapiro-Stiglitz model implies that there's a trade-off between unemployment and inflation in the short run — that's the Phillips curve — but the position of that trade-off depends on the efficiency wage. If monitoring technology improves, the trade-off shifts. If it worsens, it shifts the other way. Luna: That's actually a really optimistic angle. Because if firms get better at monitoring remote workers — say, with AI tools — then the efficiency wage premium could shrink, and we could have lower unemployment without higher inflation. Lucas: That's a hot debate right now. Some economists argue that the rise of workplace surveillance software is essentially a technological shock that flattens the Phillips curve. Others say that workers will adapt and find new ways to shirk, so the effect is temporary. Central banks are watching this closely, because if the Phillips curve is genuinely flatter, they can run a hotter economy without worrying as much about inflation. Luna: And that would mean the neutral rate of interest — r-star — might be lower than we think, because the economy can sustain more employment without overheating. Lucas: Precisely. So the Shapiro-Stiglitz model, which is over forty years old, is suddenly central to how we think about the post-pandemic economy. It's a reminder that good theory has a long shelf life if the underlying frictions — like imperfect monitoring — are real and persistent. Luna: You know, speaking of useful frameworks, it strikes me that episodes like this one are exactly why listener support matters. We don't run ads, we don't have sponsors pushing a narrative — we just get to dig into a model like this because it's interesting and relevant. Lucas: Yeah, that's the whole point. And if you find this kind of conversation valuable, the way to keep it going is simple. You can go to buy me a coffee dot com slash fexingo. That's it. No Patreon tiers, no exclusive content — just a way to say 'this is worth doing.' Luna: And we genuinely appreciate it. It keeps the show independent and lets us pick episodes based on what's interesting, not what an advertiser wants. Lucas: So back to the model. One last thing I want to mention is how the Shapiro-Stiglitz model interacts with the concept of the natural rate of unemployment. In the standard model, the natural rate is determined by structural factors like matching efficiency and reservation wages. But efficiency wages add a separate channel: the premium itself becomes part of the natural rate. So if the premium changes, the natural rate changes. Luna: That's a really clean way to put it. So the central bank can't just look at demographic trends or job matching; they also have to think about why firms are paying what they pay. Lucas: And that's why you see more central bank research papers now explicitly modeling wage-setting frictions. The Fed, the ECB, the Bank of England — they all have teams working on search and matching models that incorporate efficiency wages. It's become a standard tool in the toolkit. Luna: I guess the big question for listeners is: what does this mean for the average person? If central banks are using this model, does it affect when interest rates go up or down? Lucas: Indirectly, yes. If the central bank believes the efficiency wage premium has risen permanently, they'll think the economy can't grow as fast without generating inflation. So they'll keep rates higher than they otherwise would. That means mortgage rates, car loans, business borrowing — all of that stays higher for longer. Conversely, if they think the premium is temporary and will fade as monitoring improves, they might cut rates sooner. Luna: So the model has real-world consequences, even if most people have never heard of it. Lucas: Exactly. And that's why understanding the logic behind central bank thinking is valuable, even if you never need to calculate an efficiency wage yourself. It helps you anticipate where policy might go. Luna: Alright, so to wrap up: the Shapiro-Stiglitz model isn't just an academic curiosity. It's actively shaping how central banks interpret the labor market, especially in the wake of the pandemic. And it might determine whether we see rate cuts later this year or not. Lucas: That's the bottom line. And as we head into the second half of 2026, keep an eye on those wage reports. If wage growth stays sticky, it might not just be a tight labor market — it could be efficiency wages at work.