Labor Market Dynamics after Cost-of-Living Shocks

This paper provides causal micro evidence on how idiosyncratic cost-of-living shocks affect labor market outcomes. Focusing on energy price fluctuations as a key driver of inflation inequality, I combine twenty years of German employer–employee registry data with a representative household expenditure survey. The empirical design exploits spatial heterogeneity in energy consumption patterns across German counties, interacted with common global energy price shocks, to identify how local exposure to cost increases translates into earnings responses.
The findings show substantial earnings flexibility relative to local inflation. A one standard deviation increase in county-specific energy costs raises annual nominal earnings growth by 0.6 percentage points, offsetting around 40–45% of local cost increases within a year. Over longer horizons, labor market adjustments nearly fully compensate affected workers: 66% of costs are recovered after two years, and close to 90% within five years.
Job-to-job mobility is as an important mechanism: Workers in high-exposure counties are more likely to change employers, and, conditional on switching, obtain considerably larger earnings gains. This partially results from targeting firms with overall higher wage levels. However, job mobility explains only half of the overall pass-through. The remainder stems from on-the-job adjustments, with evidence favoring bargaining rather than increased working hours or promotions as an explanation. These responses differ systematically across groups. Younger workers and those with higher education recover costs more quickly, while older workers display little responsiveness.
To rationalize the empirical patterns, I introduce an equilibrium model of local labor markets where workers value both wages and non-pecuniary firm attributes. Cost-of-living shocks increase the marginal utility of income, thereby raising labor supply elasticities and inducing firms to adjust wages upward. I quantify the model via an indirect inference approach that targets the reduced form estimates and show that it replicates the empirical findings. The model highlights an important welfare implication: while labor market responses cushion real income losses, they impose hidden costs by pushing workers into jobs with less desirable non-wage attributes. The estimates suggest that for each euro of consumption costs, workers lose up to an additional €0.13 in non-pecuniary benfits.
Overall, the paper shows that labor market dynamics mitigate distributional consequences of relative price shocks, but (i) not without welfare costs, and (ii) only in the medium run. The findings provide new micro evidence on the interplay between inflation, labor mobility, and wage setting and have implications for debates on inflation inequality and wage–price spirals.