ECS4861 Assignment 3
(COMPLETE ANSWERS)
2025 - DUE 13 August 2025
For assistance contact
Email:
, The statement that "wage and price rigidities are necessary for Keynesian economics to explain
involuntary unemployment" is a central point of contention and development within
macroeconomic thought. While it is broadly true, the specific role and explanation of these
rigidities have evolved significantly across different schools of Keynesian thought.
Keynes's General Theory
In his seminal work, The General Theory of Employment, Interest and Money (1936), John
Maynard Keynes challenged the classical notion that a market economy would naturally self-
correct to a state of full employment. Classical economists believed that a decline in aggregate
demand would lead to a fall in wages and prices. This, in turn, would stimulate demand (by
making goods cheaper) and restore full employment.
Keynes, however, argued against this. He recognized that wages, especially money wages, were
"sticky" or resistant to downward adjustment. His analysis was built on this premise, which he
considered a realistic observation of the economy. He provided several reasons for this:
Workers' resistance to money wage cuts: Workers are more concerned with their
relative wages than with the absolute level of their money wage. They will resist wage
cuts, fearing that their wage will fall relative to other workers' wages.
Impact of wage cuts on aggregate demand: Keynes argued that a general cut in money
wages would not necessarily increase employment. A wage cut would reduce workers'
income and, therefore, their consumption spending. This would lead to a further fall in
aggregate demand, potentially deepening a recession and leading to more unemployment.
Focus on money wages: Keynes emphasized that the decision-making of employers and
workers is based on money wages and prices, not real wages. When wages are sticky, a
fall in aggregate demand leads to a fall in output and employment, not a fall in prices that
would restore equilibrium.
For Keynes, these rigidities were a crucial part of his explanation for involuntary unemployment.
Without them, the classical argument for a self-correcting economy would hold. Thus, he needed
sticky wages and prices to create the possibility of a "less than full employment" equilibrium.
Orthodox Keynesian School
Following Keynes, the orthodox or "old" Keynesian school of thought, dominant in the mid-20th
century, took wage and price stickiness as a fundamental assumption. This school, particularly
through the development of the IS-LM model, formalized Keynes's ideas. In these models, prices
were often assumed to be fixed in the short run.
The orthodox Keynesians offered a less detailed, and often more ad hoc, explanation for these
rigidities than later schools would. The focus was on the macroeconomic implications of these
rigidities: that nominal shocks (like a change in the money supply) could have a real effect on
output and employment.
(COMPLETE ANSWERS)
2025 - DUE 13 August 2025
For assistance contact
Email:
, The statement that "wage and price rigidities are necessary for Keynesian economics to explain
involuntary unemployment" is a central point of contention and development within
macroeconomic thought. While it is broadly true, the specific role and explanation of these
rigidities have evolved significantly across different schools of Keynesian thought.
Keynes's General Theory
In his seminal work, The General Theory of Employment, Interest and Money (1936), John
Maynard Keynes challenged the classical notion that a market economy would naturally self-
correct to a state of full employment. Classical economists believed that a decline in aggregate
demand would lead to a fall in wages and prices. This, in turn, would stimulate demand (by
making goods cheaper) and restore full employment.
Keynes, however, argued against this. He recognized that wages, especially money wages, were
"sticky" or resistant to downward adjustment. His analysis was built on this premise, which he
considered a realistic observation of the economy. He provided several reasons for this:
Workers' resistance to money wage cuts: Workers are more concerned with their
relative wages than with the absolute level of their money wage. They will resist wage
cuts, fearing that their wage will fall relative to other workers' wages.
Impact of wage cuts on aggregate demand: Keynes argued that a general cut in money
wages would not necessarily increase employment. A wage cut would reduce workers'
income and, therefore, their consumption spending. This would lead to a further fall in
aggregate demand, potentially deepening a recession and leading to more unemployment.
Focus on money wages: Keynes emphasized that the decision-making of employers and
workers is based on money wages and prices, not real wages. When wages are sticky, a
fall in aggregate demand leads to a fall in output and employment, not a fall in prices that
would restore equilibrium.
For Keynes, these rigidities were a crucial part of his explanation for involuntary unemployment.
Without them, the classical argument for a self-correcting economy would hold. Thus, he needed
sticky wages and prices to create the possibility of a "less than full employment" equilibrium.
Orthodox Keynesian School
Following Keynes, the orthodox or "old" Keynesian school of thought, dominant in the mid-20th
century, took wage and price stickiness as a fundamental assumption. This school, particularly
through the development of the IS-LM model, formalized Keynes's ideas. In these models, prices
were often assumed to be fixed in the short run.
The orthodox Keynesians offered a less detailed, and often more ad hoc, explanation for these
rigidities than later schools would. The focus was on the macroeconomic implications of these
rigidities: that nominal shocks (like a change in the money supply) could have a real effect on
output and employment.
