Learning Objectives
11.1 Summarize the Keynesian explanations for real-wage rigidity.
11.2 Describe the causes and effects of price stickiness according to the Keynesian model.
11.3 Analyze the effects of monetary and fiscal policy in the Keynesian model.
11.4 Explain Keynesian theories about business cycles and macroeconomic stabilization.
In Chapter 10 we presented the classical, or market-clearing, approach to business cycle analysis. In the classical approach wages and prices are assumed to adjust quickly so that markets are almost always in equilibrium. Classical economists argue that business cycles represent the economy's best response to disturbances, such as productivity shocks, so there is little justification for government attempts to smooth the cycle.
In contrast to the classicals, Keynesians are less optimistic about the ability of free-market economies to respond quickly and efficiently to shocks. One of the central ideas of Keynesianism is that wages and prices are "rigid" or "sticky" and do not adjust quickly to market-clearing levels. Wage and price rigidity implies that the economy can be away from its general equilibrium for significant periods of time. Thus a deep recession is not an optimal response of the free market to outside shocks; rather, it is a disequilibrium situation in which high unemployment reflects an excess of labor supplied over labor demanded. Keynesians believe that the government should act to eliminate—or at least minimize—these periods of low output and high unemployment. Keynesians view equilibrium as a situation in which there is no upward or downward pressure on wages.
As wage and price rigidity is the basis for Keynesian theory and policy recommendations, understanding the potential causes of rigidity is important. A telling criticism that the classicals aimed at the Keynesians in the early 1970s was that the Keynesians simply assumed that wages and prices are rigid, without giving a good economic explanation of why these rigidities occur.
After all, argued the classicals, wages and prices are not simply "given" to the economy but are the results of decisions made by millions of individuals and firms. If excessively high wages are causing unemployment, why don't unemployed workers offer to work for lower wages until firms are willing to hire them? If prices aren't at the levels at which quantities supplied equal quantities demanded, why don't firms just change their prices? In effect, the classicals challenged the Keynesians to show how wage and price rigidity could be consistent with the idea—basic to almost all of economics—that individuals and firms are economically rational; that is, they do the best they can for themselves when making economic decisions.Keynesian researchers accepted this challenge and have made progress in explaining wage and price rigidity in terms consistent with economic rationality. In the first part of this chapter we discuss some leading Keynesian explanations for wage and price rigidity. We then show how slow adjustment of wages and
prices can be incorporated into the IS-LM model, converting it from a classical model to a Keynesian model. Using this model, we discuss the Keynesian answers to the two central questions about business cycles—namely, What causes business cycles? and What should policymakers do about them?
11.1