The statement that "wage and price rigidities are necessary for Keynesian economics to
explain involuntary unemployment" is accurate, but the specific role and importance of these
rigidities have been interpreted and developed differently across various schools of
Keynesian thought. While Keynes himself acknowledged their existence, his primary focus
was on the failure of aggregate demand. Subsequent schools, particularly New Keynesian
economics, have provided more rigorous microeconomic foundations to explain why these
rigidities exist and how they are a crucial mechanism for generating involuntary
unemployment in a modern economy.
Keynes's General Theory
In his seminal work, The General Theory of Employment, Interest and Money (1936), John
Maynard Keynes challenged the classical view that flexible wages and prices would
automatically restore full employment. While classical economists saw unemployment as a
temporary condition caused by rigid wages that were too high, Keynes offered a
fundamentally different explanation.
Keynes's central argument was that involuntary unemployment is not a result of workers'
unwillingness to accept lower wages. Instead, it is caused by a deficiency in aggregate
demand. He argued that even if workers were willing to accept a pay cut, it would not
necessarily solve the problem. A widespread reduction in wages would also reduce
consumption and investment, further decreasing aggregate demand. This downward spiral
could lead to a stable equilibrium with high unemployment, which he termed an
underemployment equilibrium.
While Keynes did not consider wage rigidity to be the sole cause of unemployment, he did
recognize its importance. He noted that wages tend to be "sticky" in the short run due to
social norms, labor contracts, and workers' concerns about their relative wages. He argued
that workers are more concerned with their real wages (their purchasing power) relative to
other workers than with the nominal wage itself. This "money illusion" makes them resistant
to wage cuts, especially when they are not accompanied by a fall in prices.
Thus, for Keynes, while wage and price rigidities were not the root cause of unemployment
(that was a lack of demand), they were a necessary condition for it to persist and for the
economy to settle into a state of involuntary unemployment. Without some form of rigidity,
classical theory would hold and the economy would, in theory, adjust back to full
employment.
The Orthodox Keynesian School
The orthodox, or "neoclassical synthesis," school, which emerged in the decades following
Keynes, essentially took Keynes's ideas and integrated them into a modified classical
framework. This school, heavily influenced by economists like John Hicks, emphasized that
wage and price rigidities are the key reasons why the economy does not automatically return
to full employment in the short run.
,This interpretation posits that Keynesian principles apply in the short run where prices are
sticky, while classical principles apply in the long run where prices are fully flexible. In this
view, a negative demand shock leads to a recession because nominal wages and prices don't
fall quickly enough to clear the market. This creates an excess supply of labor, leading to
unemployment. The orthodox Keynesian school, therefore, views wage and price rigidities as
a fundamental assumption necessary for its models, such as the IS-LM model, to explain
persistent unemployment.
The orthodox view often attributed these rigidities to institutional factors like labor unions
and long-term contracts. This interpretation, however, was criticized for lacking a solid
microeconomic foundation and for making the Keynesian model seem like a special case of
the classical model, rather than a truly general theory.
New Keynesian Economics
New Keynesian economics, which developed from the 1980s onwards, is an attempt to
address the criticisms of the orthodox school by providing microeconomic foundations for
wage and price rigidities. This school of thought accepts that individuals and firms are
rational, but they operate in an environment with imperfect information and imperfect
competition. New Keynesian economists have developed several theories to explain why
wages and prices are sticky, even in the face of rational, profit-maximizing behavior.
Some of the key New Keynesian theories include:
• Menu Costs: Firms face small, "lump-sum" costs (like the cost of printing new
menus) when changing their prices. Because these costs are small, firms may choose
not to change their prices even when a change would be profitable, leading to price
stickiness.
• Staggered Wage and Price Setting: Not all firms or workers adjust their wages and
prices at the same time. This staggering creates a disincentive for any single firm to be
the first to cut prices, as it would lose relative market share. This coordination failure
contributes to widespread nominal rigidity.
• Efficiency Wage Theory: Firms may choose to pay wages above the market-clearing
level to increase worker productivity. Higher wages can improve worker morale,
reduce turnover, and discourage "shirking" (not working hard). In a recession, a firm
may be reluctant to cut wages for fear of losing productivity, even if there is an excess
supply of labor.
• Implicit Contracts: There can be an unwritten understanding between employers and
employees that wages will not be cut during economic downturns. This implicit
contract is a form of insurance for workers and helps to maintain a stable and
productive workforce.
In the New Keynesian framework, these microeconomic rigidities are the central
mechanism through which a decline in aggregate demand leads to a recession and
involuntary unemployment. Unlike Keynes, who saw rigidities as an acknowledged, but not
deeply explored, feature of the economy, New Keynesians have made explaining these
, rigidities their primary focus. They have shown how these seemingly small, rational frictions
can have large macroeconomic consequences, validating the core Keynesian insight that
aggregate demand can determine the level of employment.
explain involuntary unemployment" is accurate, but the specific role and importance of these
rigidities have been interpreted and developed differently across various schools of
Keynesian thought. While Keynes himself acknowledged their existence, his primary focus
was on the failure of aggregate demand. Subsequent schools, particularly New Keynesian
economics, have provided more rigorous microeconomic foundations to explain why these
rigidities exist and how they are a crucial mechanism for generating involuntary
unemployment in a modern economy.
Keynes's General Theory
In his seminal work, The General Theory of Employment, Interest and Money (1936), John
Maynard Keynes challenged the classical view that flexible wages and prices would
automatically restore full employment. While classical economists saw unemployment as a
temporary condition caused by rigid wages that were too high, Keynes offered a
fundamentally different explanation.
Keynes's central argument was that involuntary unemployment is not a result of workers'
unwillingness to accept lower wages. Instead, it is caused by a deficiency in aggregate
demand. He argued that even if workers were willing to accept a pay cut, it would not
necessarily solve the problem. A widespread reduction in wages would also reduce
consumption and investment, further decreasing aggregate demand. This downward spiral
could lead to a stable equilibrium with high unemployment, which he termed an
underemployment equilibrium.
While Keynes did not consider wage rigidity to be the sole cause of unemployment, he did
recognize its importance. He noted that wages tend to be "sticky" in the short run due to
social norms, labor contracts, and workers' concerns about their relative wages. He argued
that workers are more concerned with their real wages (their purchasing power) relative to
other workers than with the nominal wage itself. This "money illusion" makes them resistant
to wage cuts, especially when they are not accompanied by a fall in prices.
Thus, for Keynes, while wage and price rigidities were not the root cause of unemployment
(that was a lack of demand), they were a necessary condition for it to persist and for the
economy to settle into a state of involuntary unemployment. Without some form of rigidity,
classical theory would hold and the economy would, in theory, adjust back to full
employment.
The Orthodox Keynesian School
The orthodox, or "neoclassical synthesis," school, which emerged in the decades following
Keynes, essentially took Keynes's ideas and integrated them into a modified classical
framework. This school, heavily influenced by economists like John Hicks, emphasized that
wage and price rigidities are the key reasons why the economy does not automatically return
to full employment in the short run.
,This interpretation posits that Keynesian principles apply in the short run where prices are
sticky, while classical principles apply in the long run where prices are fully flexible. In this
view, a negative demand shock leads to a recession because nominal wages and prices don't
fall quickly enough to clear the market. This creates an excess supply of labor, leading to
unemployment. The orthodox Keynesian school, therefore, views wage and price rigidities as
a fundamental assumption necessary for its models, such as the IS-LM model, to explain
persistent unemployment.
The orthodox view often attributed these rigidities to institutional factors like labor unions
and long-term contracts. This interpretation, however, was criticized for lacking a solid
microeconomic foundation and for making the Keynesian model seem like a special case of
the classical model, rather than a truly general theory.
New Keynesian Economics
New Keynesian economics, which developed from the 1980s onwards, is an attempt to
address the criticisms of the orthodox school by providing microeconomic foundations for
wage and price rigidities. This school of thought accepts that individuals and firms are
rational, but they operate in an environment with imperfect information and imperfect
competition. New Keynesian economists have developed several theories to explain why
wages and prices are sticky, even in the face of rational, profit-maximizing behavior.
Some of the key New Keynesian theories include:
• Menu Costs: Firms face small, "lump-sum" costs (like the cost of printing new
menus) when changing their prices. Because these costs are small, firms may choose
not to change their prices even when a change would be profitable, leading to price
stickiness.
• Staggered Wage and Price Setting: Not all firms or workers adjust their wages and
prices at the same time. This staggering creates a disincentive for any single firm to be
the first to cut prices, as it would lose relative market share. This coordination failure
contributes to widespread nominal rigidity.
• Efficiency Wage Theory: Firms may choose to pay wages above the market-clearing
level to increase worker productivity. Higher wages can improve worker morale,
reduce turnover, and discourage "shirking" (not working hard). In a recession, a firm
may be reluctant to cut wages for fear of losing productivity, even if there is an excess
supply of labor.
• Implicit Contracts: There can be an unwritten understanding between employers and
employees that wages will not be cut during economic downturns. This implicit
contract is a form of insurance for workers and helps to maintain a stable and
productive workforce.
In the New Keynesian framework, these microeconomic rigidities are the central
mechanism through which a decline in aggregate demand leads to a recession and
involuntary unemployment. Unlike Keynes, who saw rigidities as an acknowledged, but not
deeply explored, feature of the economy, New Keynesians have made explaining these
, rigidities their primary focus. They have shown how these seemingly small, rational frictions
can have large macroeconomic consequences, validating the core Keynesian insight that
aggregate demand can determine the level of employment.
