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1. Wage and Price rigidities in an economy - Evaluate the statement “Wage and price rigidities
are necessary for Keynesian economics to explain involuntary unemployment” with reference to
Keynes’s general theory, New Keynesian economics and the orthodox Keynesian school.
Introduction
The debate surrounding wage and price rigidities plays a pivotal role in explaining involuntary
unemployment within various schools of macroeconomic thought. Wage and price rigidities refer to
the slow or imperfect adjustment of nominal wages and prices in response to shifts in supply and
demand (ECS4861, 2018). In classical economic theory, it was assumed that market forces, through
flexible prices and wages, would naturally bring the economy to full employment equilibrium.
However, the widespread unemployment seen during the Great Depression challenged this classical
perspective, leading Keynes to argue that economies may not always self-correct and may require
government intervention (Snowdon et al., 2005).
Involuntary unemployment, a central concept in Keynesian economics, refers to a situation where
individuals willing to work at the existing wage rate cannot find employment, contradicting classical
assumptions that unemployment is always voluntary (ECS4861, 2018). Although Keynes initially
assumed nominal wage rigidity to simplify his theory, his General Theory of Employment, Interest
and Money fundamentally questioned the classical notion of automatic market adjustments
(Snowdon et al., 2005).
Orthodox Keynesianism builds on this, emphasizing wage and price rigidities as essential to
understanding underemployment equilibrium, often illustrated in models such as the IS-LM
framework (ECS4861, 2018). New Keynesian economics, however, offers a more detailed
microeconomic foundation for these rigidities, going beyond mere assumptions. It explains why
wages and prices are sticky through mechanisms like menu costs, efficiency wages, and
insider-outsider theories (Snowdon et al., 2005). Therefore, the statement to evaluate highlights the
role of these rigidities in the Keynesian explanation of persistent involuntary unemployment, a topic
that has evolved significantly across different Keynesian schools of thought.
Keynes’s General Theory: Demand Deficiency Over Rigidities
Keynes’s General Theory of Employment, Interest and Money, published in 1936, represented a
major shift from classical economic thought by offering an alternative explanation for the
determination of aggregate output and employment. While the statement suggests that wage and
price rigidities are "necessary" for explaining involuntary unemployment, Keynes's primary
argument centers on demand deficiency as the root cause, rather than just wage stickiness (ECS4861,
2018).
Classical economists maintained that market forces, through perfectly flexible wages and prices,
would automatically restore full employment equilibrium, and that any observed unemployment was
voluntary or frictional. This view was based on Say's Law, which argued that "supply creates its own
demand," implying there could be no general deficiency in demand to cause persistent
unemployment (Snowdon et al., 2005). Keynes explicitly rejected Say's Law, arguing it was
inapplicable to the modern economy (Clarke, 2024).
1. Wage and Price rigidities in an economy - Evaluate the statement “Wage and price rigidities
are necessary for Keynesian economics to explain involuntary unemployment” with reference to
Keynes’s general theory, New Keynesian economics and the orthodox Keynesian school.
Introduction
The debate surrounding wage and price rigidities plays a pivotal role in explaining involuntary
unemployment within various schools of macroeconomic thought. Wage and price rigidities refer to
the slow or imperfect adjustment of nominal wages and prices in response to shifts in supply and
demand (ECS4861, 2018). In classical economic theory, it was assumed that market forces, through
flexible prices and wages, would naturally bring the economy to full employment equilibrium.
However, the widespread unemployment seen during the Great Depression challenged this classical
perspective, leading Keynes to argue that economies may not always self-correct and may require
government intervention (Snowdon et al., 2005).
Involuntary unemployment, a central concept in Keynesian economics, refers to a situation where
individuals willing to work at the existing wage rate cannot find employment, contradicting classical
assumptions that unemployment is always voluntary (ECS4861, 2018). Although Keynes initially
assumed nominal wage rigidity to simplify his theory, his General Theory of Employment, Interest
and Money fundamentally questioned the classical notion of automatic market adjustments
(Snowdon et al., 2005).
Orthodox Keynesianism builds on this, emphasizing wage and price rigidities as essential to
understanding underemployment equilibrium, often illustrated in models such as the IS-LM
framework (ECS4861, 2018). New Keynesian economics, however, offers a more detailed
microeconomic foundation for these rigidities, going beyond mere assumptions. It explains why
wages and prices are sticky through mechanisms like menu costs, efficiency wages, and
insider-outsider theories (Snowdon et al., 2005). Therefore, the statement to evaluate highlights the
role of these rigidities in the Keynesian explanation of persistent involuntary unemployment, a topic
that has evolved significantly across different Keynesian schools of thought.
Keynes’s General Theory: Demand Deficiency Over Rigidities
Keynes’s General Theory of Employment, Interest and Money, published in 1936, represented a
major shift from classical economic thought by offering an alternative explanation for the
determination of aggregate output and employment. While the statement suggests that wage and
price rigidities are "necessary" for explaining involuntary unemployment, Keynes's primary
argument centers on demand deficiency as the root cause, rather than just wage stickiness (ECS4861,
2018).
Classical economists maintained that market forces, through perfectly flexible wages and prices,
would automatically restore full employment equilibrium, and that any observed unemployment was
voluntary or frictional. This view was based on Say's Law, which argued that "supply creates its own
demand," implying there could be no general deficiency in demand to cause persistent
unemployment (Snowdon et al., 2005). Keynes explicitly rejected Say's Law, arguing it was
inapplicable to the modern economy (Clarke, 2024).
