ECS4861
Assignment 3
Due 13 August 2025
,ECS4861
Assignment 3
Due 13 August 2025
Question 1: Wage and Price Rigidities in Keynesian Economics
Introduction
The statement that “Wage and price rigidities are necessary for Keynesian economics
to explain involuntary unemployment” encapsulates a core distinction between
Keynesian and classical macroeconomic paradigms. Classical economics assumes that
flexible wages and prices ensure market clearing, thereby eliminating involuntary
unemployment. In contrast, Keynesian theory argues that sticky wages and prices
inhibit automatic adjustments, resulting in persistent unemployment. This essay
evaluates the necessity of wage and price rigidities in Keynesian thought by examining
Keynes’s General Theory, the orthodox Keynesian school, and New Keynesian
economics.
Keynes’s General Theory
In The General Theory of Employment, Interest, and Money (1936), John Maynard
Keynes challenged the classical assumption that markets automatically clear. He
introduced the concept of involuntary unemployment, where workers are willing to
work at prevailing wages but cannot find employment due to insufficient aggregate
demand.
A central element of Keynes’s theory is the stickiness of nominal wages, especially in
the downward direction. He attributed this rigidity to institutional and psychological
factors such as:
, • Labor contracts and unions
• Minimum wage laws
• Workers’ resistance to nominal wage cuts
This wage inflexibility prevents labor market equilibrium. Even in the presence of
surplus labor, firms do not lower wages, fearing declines in worker morale or
productivity. Furthermore, Keynes argued that even if wages fell, the reduction in
workers’ incomes would depress aggregate demand further, worsening
unemployment.
Thus, wage and price rigidities are not just auxiliary assumptions in Keynes’s
framework—they are integral to explaining why the economy can remain in a state
of disequilibrium with persistent involuntary unemployment.
Assignment 3
Due 13 August 2025
,ECS4861
Assignment 3
Due 13 August 2025
Question 1: Wage and Price Rigidities in Keynesian Economics
Introduction
The statement that “Wage and price rigidities are necessary for Keynesian economics
to explain involuntary unemployment” encapsulates a core distinction between
Keynesian and classical macroeconomic paradigms. Classical economics assumes that
flexible wages and prices ensure market clearing, thereby eliminating involuntary
unemployment. In contrast, Keynesian theory argues that sticky wages and prices
inhibit automatic adjustments, resulting in persistent unemployment. This essay
evaluates the necessity of wage and price rigidities in Keynesian thought by examining
Keynes’s General Theory, the orthodox Keynesian school, and New Keynesian
economics.
Keynes’s General Theory
In The General Theory of Employment, Interest, and Money (1936), John Maynard
Keynes challenged the classical assumption that markets automatically clear. He
introduced the concept of involuntary unemployment, where workers are willing to
work at prevailing wages but cannot find employment due to insufficient aggregate
demand.
A central element of Keynes’s theory is the stickiness of nominal wages, especially in
the downward direction. He attributed this rigidity to institutional and psychological
factors such as:
, • Labor contracts and unions
• Minimum wage laws
• Workers’ resistance to nominal wage cuts
This wage inflexibility prevents labor market equilibrium. Even in the presence of
surplus labor, firms do not lower wages, fearing declines in worker morale or
productivity. Furthermore, Keynes argued that even if wages fell, the reduction in
workers’ incomes would depress aggregate demand further, worsening
unemployment.
Thus, wage and price rigidities are not just auxiliary assumptions in Keynes’s
framework—they are integral to explaining why the economy can remain in a state
of disequilibrium with persistent involuntary unemployment.
