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 claim that “wage and price rigidities are necessary for Keynesian economics to
explain involuntary unemployment” underscores a foundational distinction between
Keynesian and classical economic paradigms. Classical theory assumes perfectly
flexible wages and prices, leading to self-correcting markets and full employment.
Keynesian economics, however, challenges this view, asserting that rigidities prevent
wage and price adjustments, thereby causing unemployment to persist. This response
evaluates the validity of this claim across three major branches of Keynesian thought:
Keynes’s General Theory, the orthodox Keynesian school, and New Keynesian
economics. In each framework, wage and price rigidities are shown to play a critical
explanatory role in the phenomenon of involuntary unemployment.
Keynes’s General Theory
In The General Theory of Employment, Interest, and Money (1936), John Maynard
Keynes argued that economies can experience prolonged periods of involuntary
unemployment due to insufficient aggregate demand. A key mechanism in this process
is the stickiness of wages and prices, particularly in the downward direction.
Keynes attributed wage stickiness to several institutional and behavioral factors: labor
contracts, minimum wage laws, collective bargaining agreements, and workers’
resistance to nominal wage cuts. Because wages do not fall in response to excess labor
supply, the labor market fails to clear, and unemployment persists.
, In contrast to classical assumptions, Keynes argued that lowering wages might worsen
unemployment by reducing workers’ incomes and thus aggregate demand. Firms,
seeing lower demand, would cut production rather than hire more workers, creating a
vicious cycle of declining output and joblessness.
In this view, wage and price rigidities are essential to explaining why the economy
does not automatically return to full employment equilibrium. They are not mere frictions
but central mechanisms in Keynes’s broader argument about macroeconomic instability.
Assignment 3
Due 13 August 2025
,ECS4861
Assignment 3
Due 13 August 2025
Question 1: Wage and Price Rigidities in Keynesian Economics
Introduction
The claim that “wage and price rigidities are necessary for Keynesian economics to
explain involuntary unemployment” underscores a foundational distinction between
Keynesian and classical economic paradigms. Classical theory assumes perfectly
flexible wages and prices, leading to self-correcting markets and full employment.
Keynesian economics, however, challenges this view, asserting that rigidities prevent
wage and price adjustments, thereby causing unemployment to persist. This response
evaluates the validity of this claim across three major branches of Keynesian thought:
Keynes’s General Theory, the orthodox Keynesian school, and New Keynesian
economics. In each framework, wage and price rigidities are shown to play a critical
explanatory role in the phenomenon of involuntary unemployment.
Keynes’s General Theory
In The General Theory of Employment, Interest, and Money (1936), John Maynard
Keynes argued that economies can experience prolonged periods of involuntary
unemployment due to insufficient aggregate demand. A key mechanism in this process
is the stickiness of wages and prices, particularly in the downward direction.
Keynes attributed wage stickiness to several institutional and behavioral factors: labor
contracts, minimum wage laws, collective bargaining agreements, and workers’
resistance to nominal wage cuts. Because wages do not fall in response to excess labor
supply, the labor market fails to clear, and unemployment persists.
, In contrast to classical assumptions, Keynes argued that lowering wages might worsen
unemployment by reducing workers’ incomes and thus aggregate demand. Firms,
seeing lower demand, would cut production rather than hire more workers, creating a
vicious cycle of declining output and joblessness.
In this view, wage and price rigidities are essential to explaining why the economy
does not automatically return to full employment equilibrium. They are not mere frictions
but central mechanisms in Keynes’s broader argument about macroeconomic instability.
