ECS4861
Assignment 3
Unique No:
Due 13 August 2025
, Wage and Price Rigidities in an Economy
Introduction
One of the key challenges in macroeconomics is the existence of involuntary
unemployment—where individuals who are willing to work at the current real wage
cannot find jobs. This challenges classical economic theory, which assumes that labor
markets always adjust to restore full employment. Keynesian economics emerged in the
aftermath of the Great Depression to counter this view, emphasizing that low aggregate
demand, rather than market imperfections alone, can lead to prolonged unemployment.
Central to this discussion is the concept of wage and price rigidities, often referred to
as nominal stickiness, which describes the tendency of wages and prices to resist
downward adjustment during economic downturns (Blanchard & Johnson, 2017). This
essay evaluates the claim that wage and price rigidities are essential for Keynesian
economics to explain involuntary unemployment, drawing from Keynes’s General
Theory, orthodox Keynesian models, and insights from New Keynesian thought.
Keynes’s General Theory
John Maynard Keynes’s groundbreaking work, The General Theory of Employment,
Interest and Money (1936), marked a significant departure from classical economic
assumptions. He refuted the idea that labor markets always clear through wage
flexibility and challenged Say’s Law, which posits that supply automatically creates its
own demand. Instead, Keynes argued that unemployment can persist not due to wage
inflexibility but because of a shortfall in aggregate demand.
Although he acknowledged that downward wage rigidity—resulting from institutional
factors like labor contracts, union influence, and psychological resistance—was
common, Keynes maintained that the primary cause of involuntary unemployment lay
elsewhere. He believed that businesses reduce hiring not because wages are too high,
but because they anticipate low demand for their goods and services. Furthermore,
even if wages were to decline across the economy, this could reduce workers’ income
Assignment 3
Unique No:
Due 13 August 2025
, Wage and Price Rigidities in an Economy
Introduction
One of the key challenges in macroeconomics is the existence of involuntary
unemployment—where individuals who are willing to work at the current real wage
cannot find jobs. This challenges classical economic theory, which assumes that labor
markets always adjust to restore full employment. Keynesian economics emerged in the
aftermath of the Great Depression to counter this view, emphasizing that low aggregate
demand, rather than market imperfections alone, can lead to prolonged unemployment.
Central to this discussion is the concept of wage and price rigidities, often referred to
as nominal stickiness, which describes the tendency of wages and prices to resist
downward adjustment during economic downturns (Blanchard & Johnson, 2017). This
essay evaluates the claim that wage and price rigidities are essential for Keynesian
economics to explain involuntary unemployment, drawing from Keynes’s General
Theory, orthodox Keynesian models, and insights from New Keynesian thought.
Keynes’s General Theory
John Maynard Keynes’s groundbreaking work, The General Theory of Employment,
Interest and Money (1936), marked a significant departure from classical economic
assumptions. He refuted the idea that labor markets always clear through wage
flexibility and challenged Say’s Law, which posits that supply automatically creates its
own demand. Instead, Keynes argued that unemployment can persist not due to wage
inflexibility but because of a shortfall in aggregate demand.
Although he acknowledged that downward wage rigidity—resulting from institutional
factors like labor contracts, union influence, and psychological resistance—was
common, Keynes maintained that the primary cause of involuntary unemployment lay
elsewhere. He believed that businesses reduce hiring not because wages are too high,
but because they anticipate low demand for their goods and services. Furthermore,
even if wages were to decline across the economy, this could reduce workers’ income
