To explain the existence of unemployment without relying solely on worker-job mismatch, Keynesians argue for rejecting the classical assumption that real wages adjust relatively quickly to equate the quantities of labour supplied and demanded. In particular, if the real wage is above the level that clears the labour market, unemployment (an excess of labour supplied overlabour demanded) will result. From the Keynesian perspective, the idea that the real wage moves ‘too little’ to keep the quantity of labour demanded equal to the quantity of labour supplied is called real-wage rigidity.
Various explanations have been offered for why real wages might be rigid. One possibility is that there are legal and institutional factors that keep wages high, such as labour market regulations, including minimum wage legislation, unemployment benefits and trade union contracts and bargaining behaviour.
Another explanation fro why a firm might pay a higher real wage than it ‘has’ to is that this policy might reduce the firm’s turnover costs, or the costs associated with hiring and training new workers. By paying a high wage, the firm can keep more of its current workers, which saves the firm the cost of hiring and training replacements. Also, by developing a reputation for paying well, the firm, can assure itself of more and better applicants for any position that it may have to fill.
A third reason that firms might pay real wages above market-clearing levels is that workers who are paid well may have greater incentives to work hard and effectively. If highly paid workers are more productive, the firm may profit from paying its employees well, even though it could attract all the workers it needs at a lower real wage. The idea that a worker’s productivity depends on the real wage received, and that therefore firms may pay wages above the market-clearing level, is the essence of the efficiency wage model.
The efficiency wage model has both ‘carrot’ and ‘stick’ aspects as to why a worker’s productivity might depend on the real wage received.
The carrot or positive incentive is based on the idea that workers who feel well treated will work harder and more efficiently. Workers who believe that their employer is treating them fairly – by paying higher wages than required to retain them and by not cutting wages in slack times – will in turn want to treat the employer fairly by doing a good job.
The stick or threat aspect of why a firm would pay a higher wage than necessary has been analysed in an economic model called the ‘shirking’ model of wage determination. According to the shirking model, if workers are paid only the minimum amount needed to attract them to a particular job, they will not be too concerned about the possibility of being fired if they do not perform well. If the job pays the minimum amount necessary to induce them to take the job, they are not much happier with the job than without the job. In this case workers will be more inclined to take it easy at work and shirk their duties, and the employer will have to bear the cost either of the shirking or of paying supervisors to make sure that the work gets done. Workers receiving a higher wage will place a greater value on keeping their job and will work hard to avoid being fired for shirking.
There are also models of price stickiness which refer to menu costs and monopolistic competition to explain why prices would not be changed in the face of temporary changes in demand.
The rigidity created by efficiency wages is a real rigidity in that the real wage, rather than the nominal wage, remains fixed. Keynesian theories also emphasize nominal rigidities that occur when a price or wage is fixed in nominal, or money, terms and does not readily change in response to changes in supply or demand. Keynesians refer to rigidity of nominal prices – tendency of prices to adjust slowly to changes in the economy – as price stickiness.
Keynesians believe that another significant weakness of the classical model is the classical prediction that monetary policy is neutral.
In the basic classical model without misperceptions, the assumption that wages and prices adjust quickly implies that money is neutral. If money is neutral, an increase or decrease in the money supply changes the price level by the same proportion but has no effect on real variables, such as output, employment, or the real interest rate. However empirical studies have led most economists to conclude that money is probably not neutral in the real world. Classical economists account for monetary non-neutrality by extending the classical model by assuming that workers and firms have imperfect information about the current price level – the misperceptions theory.
Keynesians on the other hand explain monetary non-neutrality by saying that if prices are sticky, the price level cannot adjust immediately to offset changes in the money supply, and money is not neutral.
The Keynesian explanation for the existence of price rigidity relies on two main ideas: (1) most firms actively set the prices of their products rather than taking the prices of their output as given by the market; and (2) when firms change prices, they incur a cost, known as a menu cost.
Generally, a situation in which all buyers and sellers are price takers is called perfect competition. In contrast, a situation in which there is some competition, but in which a smaller number of sellers and imperfect standardization of the product allow individual producers to act as price setters, is called monopolistic competition.
Perfect competition is the model underlying the classical view of price determination, and price rigidity is extremely unlikely in a perfectly competitive market, e.g. market for wheat. If one farmer raises its price significantly, it will simply lose its business to another farmer. However Keynesians point out that a relatively small part of the economy is perfectly competitive. They argue that price rigidity is likely in a monopolistically competitive market, where prices are fixed in nominal terms and maintained for some period of time, e.g. cinema tickets.
The second reason for price rigidity given by Keynesians is the costs incurred by having to change prices – menu costs, e.g. reprinting price lists, or a restaurant having to reprint its menu.
Clearly, if firms incur costs when changing prices, they will change prices less often than they would otherwise, which crates a certain amount of rigidity.
As I have explained above, the extent of the flexibility of wages and prices determines their speed of adjustment. The more rigidities that exist the less flexibility is present and the slower the speed of adjustment of wages and prices.
According to the New Classical view, what can be accomplished with an activist monetary policy? Why?
In the basic classical model, money is neutral, which means that changes in the nominal money supply change the price level proportionally but do not affect real variables such as output, employment, and the real interest rate.
According to the extended classical model based on the misperceptions theory, only surprise changes in the money supply can affect output. An anticipated increase in the money supply causes price expectations to adjust immediately and leads to no misperceptions about the price level and the money supply is neutral in both the short and long runs.
However because classical economists believe that the price adjustment process is rapid, they view the period of time during which the price level is fixed – and money is not neutral – to be too short to matter.
The misperceptions theory is based on the assumption that producers have imperfect information about the general price level and hence do not know precisely the relative prices of their products. When producers have imperfect information about the general price level and hence do not know precisely the relative prices of their products. When producers misperceive the price level, an increase in the general price level above the expected price level fools suppliers into thinking that the relative prices of their goods have increased, so all suppliers increase output. The short-run aggregate supply (SRAS) curve shows the aggregate quantity of output supplied at each price level, with the expected price level held constant. Because an increase in the price level fools producers into supplying more output, the short-run aggregate supply curve slopes upwards, as shown by SRAS(1).
In the long run producers learn about the price level and adjust their expectations until the actual price level equals the expected price level. Producers then supply the full-employment level of output, ỹ, regardless of the price level. Thus the long-run aggregate supply (LRAS) curve is vertical at y=ỹ.
If the public has rational expectations about macroeconomic variables, including the money supply, the central bank cannot systematically surprise the public because the public will understand and anticipate the central bank’s pattern of behaviour. Thus classical economists argue that the central bank cannot systematically use changes in the money supply to affect output.
The New-Classical view towards an activist monetary policy is that it will accomplish nothing in the long-run but give inflation of prices. The reasoning behind this is the vertical long run Phillips Curve.
The Phillips Curve (PC) makes evident an inverse relationship between inflation and unemployment. However there are problems with the PC in the short run.
The PC seemed to describe adequately the unemployment-inflation relationship in the 1960’s, during the second half of the decade some economists, notably Milton Friedman and Edmund Phelps, questioned the logic of the PC. They argued purely on the basis of economic theory that there should not be a stable negative relationship between inflation and unemployment. Instead, a negative relationship should exist between unanticipated inflation and cyclical unemployment. The PC ignored expectations. In the short run, if there are unanticipated changes in demand, then output and employment may increase above the full employment level, ỹ. But, if changes in demand are fully anticipated, then the economy will not shift away from ỹ.
Lets assume that the economy is at (or above) full employment, never below it.
Stage 1: The money supply increases at 10% per annum. Aggregate demand increases at 10% per annum. This is expected to continue forever.
In the short-run firms run down inventories, hire more labour. Therefore output increases above ỹ and so do prices.
In the long-run since the economy is already at full employment, it is not really possible to continue working above ỹ indefinitely. Prices will keep increasing and the supply curve shifts upwards until it reaches AS(2), i.e. the economy is back at ỹ.
So the results of anticipated increases in the money supply: Employment level is unchanged. But prices are now higher (110 > 100).
Stage 2: Money supply unexpectedly increases by 15%. Aggregate demand increases by 15% to AD(3).
But, firms are expecting a 10% increase in aggregate demand. Therefore, the AS curve only shifts to AS(2), i.e. the equilibrium is at, ẽ.
So the results of the unexpected increase in demand: Employment is above the full employment level, ỹ. Prices are also higher (110 < 113 < 115).
This is what one would expect from the PC: a negative relation between inflation and unemployment. Therefore, Friedman and Phelps argue that the PC only holds if demand changes unexpectedly.
However this cannot continue for long. The excess of demand over supply leads to increased prices and suppliers soon move back to ỹ.
In the long run the economy cannot stay away from ỹ for long.
Friedman and Phelps, giving the above reasoning hypothesized the, Expectations augmented PC. The expectations-augmented PC implies that, the actual unemployment rate equals the natural unemployment rate. Therefore, the actual unemployment rate equals the natural rate in the long run regardless of the inflation rate maintained. Thus the long run Phillips curve is vertical.
The vertical long-run PC is related to the long-run neutrality of money. Classical and Keynesian economists agree that changes in the money supply will have no long-run effects on real variables, including unemployment.
The vertical long-run PC carries the notion of monetary neutrality one step further by indicating that changes in the growth rate of money, which lead to changes in the inflation rate, also have no real effects in the long-run.
Classical economists say that there is monetary neutrality. A change in the nominal money supply changes the price level proportionally but has no effect on real variables. Therefore a monetary expansion is rapidly transmitted into prices and has at most a transitory effect on real variables; i.e. the economy moves quickly from situation to situation / equilibrium to equilibrium – prices adjust quickly.
