Causality between Prices and Wages: VECM Analysis for EU-27

The literature on causality as well as the empirical evidence clearly shows that there are two opposing groups of economists, who support different hypotheses with respect to the flow of causality in the price-wage causal relationship. The first group argues that causality runs from wages to prices, whereas the second argues that effect flows from prices to wages. Nonetheless, the literature review suggests that there is at least some consensus in that researcher’s conclusions may be contingent on the type of data employed, applied econometric model, or even that relationship may alter with economic cycles. This paper empirically examines the price-wage causal relationship in EU-27, by using the OLS and VECM analysis, and it also provides robust evidence in support of a bilateral causal relationship between prices and wages, both in long-run as well as in the shortrun. Prior to designing and estimating the econometric model we have performed stationarity tests for the employed price, wage and productivity variables. Additionally, we have also specified the model taking into account the lag order as well as the rank of co-integration for the co-integrated variables. Furthermore, we have also applied respective restrictions on the parameters of estimated VECM. The evidence resulting from model robustness checks indicates that results are statistically robust. Although far from closing the issue of causality between prices and wages, this paper at least provides some fresh evidence in the case of EU-27.