In categorizing schools of thought, we are imposing a simplification on an extremely complex structure. Such simplification is subject to the pitfalls of any theory, that abstraction requires some departure from reality. But in any sphere of existence, including that of formal theory, some categorization is necessary to impose some order on our observations of the world.[2]
Macroeconomic theory, as it exists today, has emerged as a consequence of the development of intertwined macroeconomic schools of thought. The purpose of this essay is not to provide a definitive analysis of the history of macroeconomic thought but to provide a synopsis of what the authors regard to be the core influential schools of thought. Each school will be analysed in a general sense with particular emphasis being put on certain areas such as their attitudes to price flexibility, expectations and government intervention and a brief insight into their favoured methodological practices will also be touched upon. From this it is hoped that the reader will have a clearer understanding of how macroeconomic thought has developed over the last century and how the macroeconomic schools of thought, while often conflicting, are interrelated.
The assumptions of the neo-classical theory are highly restrictive, since the school eschewed behavioural or psychological theories and assumed that man was a rational utility-maximiser. Markets were competitive and prices were flexible to clear markets in the long-run. Furthermore agents were assumed implicitly to have perfect information about all present and future relative prices. The main analytical technique was comparative statics (comparing equilibrium states) but neoclassicists were also concerned with dynamic adjustment processes, trying to demonstrate that markets tended to equilibrium. They proposed (i) the existence of a long-run general equilibrium (ii) Say's Law and (iii) the classical dichotomy between real and monetary variables. We will discuss each of these in turn.
(i) General Equilibrium exists where for a given set of prices, individuals' optimal outcomes are co-ordinated: in other words, where at current prices all markets clear. Proof of the existence of General Equilibrium, and proof that an economy tends towards it, confirmed the existence of Adam Smith's invisible hand and refuted the proposition that a market economy is unstable. Its existence under restrictive conditions was proved by Leon Walras but we will not give the proof here. Adjustment to General Equilibrium is stimulated by the assumption of a Walrasian auctioneer, who calls out to all agents a price vector, and is told of their planned decisions given that vector. He reduces price where there is excess supply, and increases it where there is excess demand. He continues to call out and adjust the price vector until all markets clear. Only then does trade take place. This "tatonnement" mechanism is consistent with the assumption we mentioned at the start, that all agents have perfect information thus they only trade at the equilibrium price. The assumption was only later made explicit by Kenneth Arrow and Gerard Debreu who proved the existence of General Equilibrium based on a complete set of futures markets in all goods and factors including labour (Arrow-Debreu securities).
(ii) Say's Law was one of the main doctrines of the Classical school and was inherited by the neo-classicists. It states that supply calls forth its own demand for the economy as a whole. In other words, income is supply-determined since individuals' income equals the return on factors of production, which equals the value of firms' supply, and therefore the value of individuals' demand equals the value of firms' supply. This depends on two key propositions (i) any income which is not used for consumption demand is used for capital demand, or S = I (ii) the value of firms planned supply equals the value of workers planned demand, or in other words, there is equilibrium in the labour market. The neo-classicists market-clearing assumptions imply that savings and investment are made equal by the interest rate, and that labour demand and labour supply are made equal by the real wage rate at the rate of voluntary unemployment (i.e. that caused by unions or factor immobility). By Walras' Law, which states that the sum of effective demands must be zero, equilibrium in the markets for labour and capital implies equilibrium in the goods market. To recapitulate, if supply increases then the payments to factors match supply and given S=I and Ld =L s supply calls forth its own demand.
(iii) The third proposition is the Classical dichotomy between monetary and real variables, which depends on Say's Law. Variations in the quantity of money do not affect real variables in the long term (although of course the absence or presence of money is vital to the level of output). To show this, we begin with Marshall's and Pigou's demand for money function, Md=kPY which makes money demand a stable function of nominal income. Setting money supply (exogenous) equal to money demand we have M=kPY. However by Fischer's Quantity Theory, MV=PT identically. Taking Y as a proxy for T,transactions, we can see that by the equations MV=PY and M=kPY that V equals 1/k. Therefore stability of money demand implies stability of V. An increase in the money supply will cause an equal increase in expenditure. This may have real effects in the short term but in the long run output is determined by supply which is exogenous. Therefore changes in the money supply only affect the price level in the long run.
In conclusion the economy tends to full employment. This is a long run analysis but the neo-classicist proof of tendency to general equilibrium shows that under restrictive assumptions the economy will tend to a level of output determined by supply.
Firstly, one should have an understanding of Keynes methodology. The General Theory was not econometrically or empirically based, though it clearly addressed empirical questions arising from the Great Depression of the time, nor is it mathematical in its exposition despite Keynes' own grounding in mathematics. It is discursive in its approach, reflecting Keynes' reluctance to rely on mathematics or even graphical representation. The analysis uses aggregation of investment and consumption to generate a total demand for the economy. Within his analysis Keynes stressed psychological factors and the problem of uncertainty to a greater extent than his predecessors. These and other innovative points are best seen in the theory itself.
In the neo-classical model aggregate supply equals aggregate demand at full employment. Keynes, however, introduced a theory of effective demand where equilibrium may or may not generate full employment. Effective demand is the level of aggregate demand determined by consumption, investment and government spending, assuming a closed economy. Households communicate the value of their level of demand to the market via expenditure decisions, if this is equal to the demand expected by firms then there is an equilibrium. If they are not equal then firms will modify their prices, output and employment decisions to achieve an equilibrium. Thus demand determines supply, the inverse of the classical postulate in Say's Law. Crucially Keynes proposed that there is no reason to believe that this equilibrium will not be sufficient to generate full employment, hence the Keynesian possibility of the existence of an unemployment equilibrium.
Keynes had an impressive and original analysis of the components of effective demand. Central to this theory are the consumption function, the multiplier, the marginal efficiency of capital and liquidity preference theory. We will discuss each briefly.
Keynes claimed that by a fundamental psychological law consumption is mainly a function of current disposable income. The marginal propensity to consume (MPC) out of additional income is constant and less than unity. This means that as income rises, consumptions share in income will fall. Furthermore, a positive MPC generates the multiplier effect whereby an increase in one of the autonomous components of aggregate demand will cause a disproportionate increase in income. The extent of this effect is captured in the multiplier formula, 1/(1-MPC), which can be adapted for marginal taxation and propensities to import.
Keynes believed that investment was determined by the expected future returns to capital, which it is vital to note are uncertain. The marginal efficiency of capital (MEC) is the discount rate that equalises expected earnings and the investment outlay. If the MEC is greater than the interest rate, then investment will occur. In the aggregate this implies that as investment increases the MEC decreases as the more profitable investment opportunities are availed of. This means a downward sloping investment schedule which is not necessarily elastic with respect to the interest rate. It may depend more on confidence in the state of the economy.
Accompanying Keynes' theory of investment is his theory of how the money market determines the interest rate. The reasons for holding money are cited as the transactionary, precautionary and speculative motives, of which the latter is an innovation. He assumes that money as an asset is highly substitutable with bonds, and thus money demand is a negative function of the interest rate paid on bonds, which is the opportunity cost of holding money. Moreover there exists a special case known as the liquidity trap where the interest rate elasticity of money demand is infinite at a low enough level of interest rates. Everyone thinks they will rise and reduce the value of bonds, so only money is held. Ultimately, the important point to note is that the interest rate represents the price of money and it is determined by the intersection of money demand and money supply, as with the demand and supply of any good.
Keynes unites these assumptions in his analysis of the Great Depression. The Wall Street Crash reduced wealth, which reduced the MPC. Classical economics postulates that the equivalent rise in savings would cause the interest rate to fall until investment rose to meet the rise in savings. Keynes rejected this in noting that there is imperfect information: savings as a form of postponed consumption will not allow investors to anticipate the future demand, and the fall in consumption will depress confidence. Hence he concluded that investment will not rise to meet the increase in savings. Given a fall in the MPC, and no significant change in investment, the level of aggregate savings will be lower, Thus savings and investment will be in equilibrium, not through the interest rate rising but through income falling The crucial point to note is that income will equilibrate savings and investment. This analysis clearly shows that the equilibrium in the economy is not necessarily full employment equilibrium. If it is an unemployment equilibrium, then one may ask why wages don't fall to equilibrate the labour market. Keynes posited the "sticky wage" phenomenon whereby workers resist downward movements in wages. Yet even ignoring this, Keynes claims that a fall in the wage rate will have an indeterminate effect on the economy. It could depress consumption, or it could increase employment; hence an economy cannot be relied upon to self adjust through the wage rate.
Keynes' analysis also highlights the monetary transmission mechanism whereby an increase in the money supply may, at least in the short run, cause a fall in the interest rate and a rise in the associated levels of investment and income. However, the validity of monetary policy in this sense is strongly questioned as Keynes posited a highly elastic money demand function with respect to the interest rate, and highly inelastic investment demand schedule with respect to the interest rate. Clearly the efficacy of monetary policy as an influence on income would be weak under these assumptions.
What then did Keynes propose as a solution to the deficiencies of effective demand and the associated unemployment equilibrium? Although the General Theory was not a policy book it did note the need for a socialisation of investment, i.e. fiscal policy. The issue appeared to be the inability of investment to match the increases in savings and thus there is a role for the government to compensate for this under-investment via public works.
The message taken from the General Theory was to prepare for government. The Keynesian revolution that followed caused governments the world over to use fiscal policy to stimulate their economies and combat unemployment. Keynesian economics is inextricably linked with government spending or demand management. Interestingly, however, in the years that followed Keynes theory was analysed in the Hicksian IS-LM framework which was a part of the neo-classical synthesis. Keynes himself did not at the time criticise this model and thus it dominated the research agenda for decades to come.
The Neoclassical Synthesis was an attempt to reconcile these two theories. It was largely based on the classical model ,assuming rational agents like the classical doctrine, but differs from it in saying that wages and prices may be sticky. This element was presumed to be the Keynesian element of the analysis. But since price-wage stickiness was not crucial to Keyness proposal of unemployment equilibrium, the assumption reduces Keyness proposal to being short-run in nature. In the long run wages adjust to bring about labour market equilibrium, and the price level adjusts to set aggregate demand equal to a given level of supply, validating Says Law. Although Samuelson did important work on growth theory, short-run analysis was the main area of interest of this school.
IS-LM analysis is used to explain how unemployment arises in the short run. This framework was developed by Sir John Hicks to reduce Keyness theory of income determination to two crucial relationships on the same diagram. The IS curve is the locus of (Y,r) combinations consistent with equilibrium in the goods market, i.e. injections equal to leakages. The LM curve is the locus of those combinations consistent with equilibrium in the money market, i.e. money supply equal to money demand. The IS curve is downward sloping because goods market equilibrium requires that savings, a positive function of Y, equal investment, a negative function of r. The LM curve is upward-sloping because money market equilibrium requires that money demand, a positive function of Y and a negative function of r, remain equal to a fixed level of money supply. Their intersection gives the equilibrium levels of Y and r in the short run. As far as it goes, this is a Keynesian analysis since quantities rather than prices adjust to keep the economy in equilibrium. Because of this insufficient demand will cause not a fall in price but an increase in unemployment.
The clearing of the labour market through wage adjustment implies no role for government intervention in the long run, but in the short run the level of unemployment is considered to be subject to influence by aggregate demand management. Samuelson proposed that the government should keep output and unemployment at their long-run levels, preventing them from fluctuating too much from trend, by affecting the level of aggregate demand. This was considered desirable both in itself and to reduce uncertainty for investors. Econometric models with many equations and many variables, based on the above IS-LM and labour market analysis, were used to time such intervention.
To decide what form intervention should take, the IS-LM analysis was used to compare the relative merits of fiscal and monetary policy. In this framework the debate reduces to one over the relative slopes of the two curves, which depends on the magnitude of several parameter elasticities, especially the interest-rate elasticities of money and investment demand. One of the main concerns of the synthesis was the estimation of such elasticities using econometrics. The synthesis thus set an empirical rather than a theoretical agenda. They found that at the time of analysis the interest rate elasticity of money demand was not as low as suggested by proponents of the liquidity trap. On the other hand they found that investment was quite unresponsive to the interest rate, and concluded that confidence was more important. Most supported the use of government spending to stabilise the economy, and until the 1970s this was the dominant economic policy of Western governments. Monetary policy was reduced to a supporting role except in the United States where the political system made fiscal policy an unresponsive tool.
Support was given to the idea of government intervention by the empirical work of William Phillips, who found a negative relationship between historical British wage inflation and unemployment. The modified version, with price inflation, implied that governments faced a short-run tradeoff between these two variables. This supports the short-run theory of aggregate supply. However, the analysis was abused in the suggestion that governments could choose the level of unemployment if they accepted a given rate of inflation. It was the breakdown in the long term of such a false relationship and of econometric models on the above analysis that discredited the whole synthesis, when high unemployment and inflation were found to coexist in the 1970s. The gap was filled by a number of competing schools, each critical of the synthesis, either on the grounds that it misinterpreted Keynes, or because its microeconomic foundations were unsystematic. No synthesis has been achieved since.
They assume that individuals are rational utility maximises with adaptive expectations - that is, the expectation of a macrovariable is a weighted average of its past values. Markets clear in the long run. This leads them to the following propositions:
(i) the money supply is the sole determinant of nominal income ( in the short run ) and inflation ( in the long run ) ;
(ii) monetary policy is more effective than fiscal policy in influencing short-term national income;
(iii) a fixed rate of monetary growth will be a better stabiliser of income around its trend than an active stabilisation policy, and will result in a lower long-term rate of inflation.
(i) is really a reformulation of the old quantity theory of money. In the identity MV=PY, monetarists claim that Y is exogenous in the long run and V may be treated as stable. The stability of V is based on the monetarists view of money demand. We have seen in the discussion of the old quantity theory that if money demand is a fraction of nominal income kPY, then this means that V=1/k. where we set money demand equal to money supply in the above identity. But like the old quantity theorists, the monetarists believe that nominal money demand can be represented as above. They believe that individuals aim to hold a fraction of their real wealth as real cash balances, and thus money demand is a function of permanent nominal income. k is a negative function of the opportunity cost of holding money, which depends on the return available on other assets, and a positive function of wealth. These factors can be relied upon to evolve more slowly over time than the money supply and prices and so velocity may be assumed stable. Monetarists also believe that changes in M in the above identity cause changes in nominal income. If individuals are holding the cash they desire at a given level of nominal income and their money holdings are increased then they will try to get rid of the money by spending it . Society as a whole cannot get rid of money in this way and adjustment comes about when nominal income rises. Therefore in the long run, with Y exogenous, there is a stable link between money and inflation.
(ii) This theory is also used to show that monetary policy is superior to fiscal policy. It differs from the Keynesian theory in several ways. Firstly, the money stock is supply- not demand-determined. Secondly, bonds are assumed not to be a close substitute for money. This refutes the Keynesian liquidity trap, which says that the high interest-elasticity of money demand invalidates monetary policy. Money market equilibrium will be restored by an infinitisimally small change in r rather than through a change in income. If, as the monetarists suggest, money and bonds are not close substitutes then equilibrium may come through income increasing Moreover the fact that money demand is insensitive to interest rates means that if fiscal policy increased money demand, a large rise in interest rates would be required to restore equilibrium, which would mean crowding out of private investment. Moreover the Keynesian multiplier is refuted by Friedmans permanent income theory, which says that individuals will not change their spending patterns in response to a perceived short-term change in income. If the MPC is zero then the multiplier is only unity.
(iii) This proposition is a refutation of Samuelsons countercyclical stabilisation policy advice. Monetarists argue that the government should not try to stabilise since it cannot anticipate shocks (the expected value of income is its trend value). Moreover, once a shock has occurred policy lags will mean that by the time a government affects the economy, the effect will be inappropriate (since the expected value of income will still be the natural rate of unemployment). Furthermore, pursuing a low monetary growth rate changes the behaviour of agents in an economy. Here monetarists refute the Phillips Curve. Over time attempts to reduce unemployment below its trend will cause the labour market to expect such a policy and (since it is at the natural rate) to increase wages by as much to allow for the inflation. Then if the government wants to have an effect, it will need an even higher monetary expansion. Eventually there will be hyperinflation or the costs of disinflation. The latter is the more costly because expectations have been raised in the past. It is impossible to stabilise inflation at a high level since inflation affects the velocity of circulation by reducing the opportunity costs of holding money, whereupon the new velocity of circulation causes a new level of inflation. There is no steady state and the resulting uncertainty has welfare costs. Maintaining a low growth rate consistent with low inflation will over time moderate agents wage claims and act as a stabiliser (income rising automatically causes deflation, and income falling causes reflation).
The monetarists also developed a highly elegant and distinctive, though controversial, methodology. Friedman argued for methodological positivism : theories ought to be confirmed or rejected by their stochastic predictions, not by the realism of their assumptions. Many of the monetarists claims were supported more by empirical evidence than by theory. Where the neo-classical synthesis had used econometrics to forecast variables with systems of many equations and to find elasticities, the monetarists used it to test reduced-form models. The most important example of this is Milton Friedmans and Anna Schwartzs Monetary History of the United States. Monetarists had often been criticised for black box monetarism: that is, attributing causality to M without explaining the transmission mechanism. Friedman and Schwartz supported the claim, not by theory, but by testing for and finding a stable relationship between M and P in the United States over a century. A criticism was made of Friedman and Schwartz, that correlation does not imply causality and that one needs theory to interpret such results. Nonetheless this methodology of the monetarists is at least as distinctive as their theory.
Equilibrium in the neo-classical model was reached because there was perfect knowledge of all present and future prices. All trading took place at equilibrium prices because of the existence of the Walrasian auctioneer and the tâtonnement mechanism. Clower and Leijonhufvud believed that the removal of the Walrasian auctioneer was fundamental to Keyness analysis of fix-price, as opposed to auction, markets. This has important implications for the attainment of equilibrium.
Leijonhufvud attempted to show that the main features of Keyness model - the multiplier, the MPC and the separation of savings from investment - were caused by the absence of a futures market in labour and the existence of money which interfered with the signalling mechanism of a market economy. These features of a market economy made unemployment possible. Leijonhufvud believed that these issues were neglected by the Classical school and the Keynesian orthodoxy of the 1960s who analysed the economy as a real exchange economy (an economy that uses money but it recognises it only as means of exchange i.e. it is not seen as entering into the decisions or motives of individuals).
Leijonhufvud saw the multiplier as an illiquidity phenomenon. Temporary variations in income would tend to be exacerbated by the multiplier effect because of the absence of perfect capital markets so that some individuals can not borrow against future earnings and smooth consumption patterns. In the theoretical general equilibrium this realised income constraint could be broken by a forward sale of labour. This means that workers would sell the right to their labour in the future to finance present expenditure which would create a demand for their labour. But in reality, there is no such arrangement. Hence the situation could arise in which an excess supply of labour could exist and demand could be below its potential level, but there would be no way of eliminating these discrepancies. Furthermore, the existence of money in the economy may distort the signals necessary for an efficient allocation of resources.
In the Classical model a decision to save is a decision to consume in the future. Classical analysis postulates that an increase in saving (a fall in consumption) will lead to an increase in investment equal to the fall in current consumption because the extra future demand makes it profitable to do so. Leijonhufvud argued that while this will occur in a barter economy it will not occur in a monetary economy. In a barter economy the only way to save is to buy a claim to purchase a specific good at a specific time in the future. A change in relative prices will ensure that people recognise the profitability in producing that good and will invest. In a monetary economy the rate of interest is the only signalling device but it is imperfect because producers dont know which goods will be in greater demand in the future.
Clowers analysis also centred on the difference between a barter economy and a monetary economy. In the barter economy of Walrasian general equilibrium people have a unified decision process in that the amount of work a person does determines his consumption of goods. In a monetary economy an individual faces a dual decision whereby people have to sell their services before they can purchase goods. As a consequence of the existence of money full employment may be unobtainable. If unemployed workers were employed by firms they would buy the goods which would make it profitable for firms to employ them. However, no individual firm will do this since the workers will only spend a fraction of their income on goods from that particular firm. There is no way that labour as a whole can signal to producers as a whole that if they employed them they (the workers) would consume the output produced.
Clower and Leijonhufvud sought to provide a more rigorous microfoundation for Keyness claim that the economy can remain for long periods of time away from the market-clearing equilibrium. Thus, non-Walrasian equilibria were seen to exist. The work of Clower and Leijonhufvud was important in the development of other strands of Keynesianism such as the New Keynesian school.
Like any school of thought, the New Classicists base their theories on a general set of assumptions. The first assumption, that agents real economic decisions (such as those about consumption or investment) are based solely on real (as opposed to nominal or monetary) factors, is shared with the Classical school. The new or radical aspect of New Classicism comes with the assumptions that agents are consistent and successful optimizers and that they make no systematic errors in evaluating the economy. The former assumption implies that agents are continuously in equilibrium and hence that the markets clear continuously. This is inconsistent with the microfoundations of the neo-classical synthesis where rationality was assumed but continuous market-clearing was not. Thus, while most Classical economists treat equilibrium as a limiting case the New Classical economists believe it to be always obtaining. The other assumption, that agents make no systematic errors, is simply saying that agents hold rational expectations. Rational expectations are a necessary but not a sufficient condition for New Classical economics in that the latter does not exist without them but rational expectations can exist without the associated school[5].
Alongside these assumptions the New Classical school has two associated models. These are the Lucas-Islands model and the real-business-cycle model. In the former model the Lucas supply function or the surprise supply function is an off-equilibrium (very) short-run phenomenon. This supply function accounts for deviations in Y by imposing constraints on agents decision-making processes. The existence of imperfect information and uncertainty means that people will make mistakes even when their decisions are rational This is why the AS curve is upward-sloping (i.e. not vertical) in the very short-run.
Towards the end of the 1970s confidence in the Lucas supply approach dwindled, mainly as a result of it being invalidated by econometric studies, and the alternative real business cycle approach emerged. Real business cycle theory, as developed by Kydland and Prescott, holds that nominal variables, such as the money supply and the price level, do not influence real variables, such as employment and real GNP. Fluctuations in these real factors can only be explained by real changes in the economy. The business cycles emerge as a result of changes in people's willingness to trade off work and leisure between the present and the future. This occurs as a result of anticipated changes in the relation between the current and the future real wage rate. The business-cycle theory, thus, re-emphasises the microfoundations of the macroeconomy to highlight the possible existence of cycles in a generally equilibrating economy.
The combination of these models and the underlying assumptions of the school leads to the main conclusions of the New Classical theory. Firstly, the New Classicists argue that all markets behave as if they are perfectly competitive. This means that involuntary unemployment does not exist and there is a unique natural rate of unemployment (Y*) determined by the labour market. In association with this is the conclusion that only price or wage surprises will cause the economy to diverge from Y*. This argument is linked to the final conclusion of the school, which is directly linked to the rational expectations assumption, that people do not make systematic mistakes and as such there is no systematic pressure for output and employment to deviate from equilibrium.
The New Classicists are of the view that real variables are not exploitable by policy makers. This is the infamous policy ineffectiveness result which argues that no systematic stabilisation policy, neither fiscal nor monetary, has any real influence on the economy. Only nominal variables, such as inflation, are effected. Policy can only have a real effect if it is unanticipated. Only when information is hidden from the agents will policy be able to surprise the system. This school of thought also analyses the issue of time inconsistency with regard to public policy. Kydland and Prescott (1977) note that the existence of time lags between the time when policy is needed and when it is implemented means that the policy initially advocated may no longer be useful because of changing underlying economic variables over the lag period. Associated with this New Classical policy analysis is Lucass econometric policy evaluation critique which argues that econometric results should not be used to direct policy because once a policy action is taken the underlying parameters of the econometric model change and the original policy prescribed would no longer be necessarily preferable.
The New Classical school of thought is built entirely on the foundations of market clearing and optimisation by rational economic agents. These assumptions, combined with the Lucas-Islands model and the real business cycle model, lead to the conclusions of continuous equilibrium and policy ineffectiveness. While these conclusions seemed self-explanatory to the proponents of this view they were not accepted by all and in the 1970s economics reverted back to the old Classical-Keynesian debate (albeit a different version of it) with the emergence of the New Keynesian school.
New Classical economics, with its belief in flexible wages and prices and its assumption of rational expectations, concluded that the elasticity of nominal income with regard to nominal demand was zero. Variations in demand were reflected in variations in the price level and markets cleared. New Keynesian economics assumes that prices and wages are sticky and hence quantities (as opposed to prices) adjust to changes in demand. Hence markets dont clear and sticky prices are seen as the barrier. Much of New Keynesian work has thus focused on finding the necessary conditions for price and wage stickiness.
Initially New Keynesians focused on nominal wage rigidities to explain this. Stanley Fischer developed a sticky wage model in which deviations in output from its natural rate are as a result of deviations in the price level from its expected level :
Y=Ye + (P-Pe)
Although expectations are rational an increase in the money supply over and above the expected level will produce a price level which will exceed its expected level. This implies, since contracts are assumed to be set in nominal terms, that real wages will fall, more people will be employed and output will increase above its natural level. The converse applies if the expected price level is above its actual level. In the long run, however, the economy may return to full employment but in the case of a negative shock to demand a process of hysteresis may occur whereby unemployed workers find it difficult to compete in the labour market and eventually join the ranks of the long term unemployed who can exert no influence on wages. This nominal wage stickiness would have a critical effect on output in the short-run and long-run.
However, theories of nominal wage rigidity are not supported by the evidence. If nominal wages were sticky then real wages would tend to be countercyclical. If nominal wages were sticky a rise in inflation (arising from a boom) would drive real wages down and a fall in inflation (generally caused by a recession) would cause real wages to rise. However, real wages are not countercyclical and if anything are procyclical.
Attention has thus turned to studies of real wage rigidity. Two main theories of real wage rigidity exist: (i) Implicit Contract Theory and (ii) Efficiency Wage Theory. Implicit Contract Theory states that because workers and employers differ in their attitude towards risk (workers tend to be risk averse and firms risk neutral) firms and workers enter into an unwritten implicit contract which maintains real wages steady regardless of changes in nominal demand. Because of this insurance workers pay is generally lower than it otherwise would have been. Typically implicit contracts will entail much greater stability of real wages and corresponding instability of employment than the standard auction type model would predict. Workers voluntarily enter into contracts in which they recognise ex ante the firms right to lay them off during hard times. However, this unemployment may not be involuntary as workers voluntarily enter into an agreement even though they know of the risk of unemployment.
A more satisfactory theory has come in the form of Efficiency Wage Theory which believes that the productivity of workers is a function of the wage they receive. Hence it is in the interests of employers to pay wages above the equilibrium level. An excess supply of labour will manifest itself in terms of an increase in unemployment rather than a fall in real wages. Labour productivity is a factor of real wages for a number of reasons: (i) In LDCs higher nutrition levels increases productivity, (ii) high real wages should increase the cost to the worker of slacking hence productivity will be high, (iii) high real wages will tend to attract the best workers so that an adverse selection process may exist. Another theory accounting for wage stickiness is insider/outsider theory, which says insiders (the workers) maintain wages above market clearing level excluding outsiders from working by means of union threat. As a result of Efficiency Wage Theory and insider/outsider theorythe economy is seen as settling at an equilibrium level of involuntary unemployment. Changes in the productivity of workers, in technology, in the capital stock, or in unemployment compensation will all lead to changes in the equilibrium level of unemployment.
New Keynesian economists regard imperfect competition as the typical description of market structure in many industries. They have begun to focus on price setting behaviour in the hope that it will result in a more satisfactory explanation of unemployment equilibrium than that provided by sticky wage theories. When the emphasis is shifted to price setting the hypothesis is that firms lay off workers in recessions not because of wage rates that are far too high, but because prices have not been adjusted downward in response to market conditions and sales are too low.
A number of fix price theories exist: (i) Prices may be much more responsive to changes in costs than to shifts in demand because there may be implicit contracts between sellers and buyers , whereby price increases based on cost increases are generally accepted as fair, but those that are perceived as taking advantage of short-run market conditions on the demand side are deemed to be unfair, (ii) sticky prices may also arise when there are costs to adjustment called menu costs. Menu costs may be small to the firm but they imply a negative externality. If all firms change their prices their real balance effect will outweigh the cost. Other theories which explain sticky prices focus on the staggering of prices and co-ordination failures. Because price adjustment occurs at different times for different firms they may not respond to changed demand by changing prices in the knowledge that they will lose customers, etc. Co-ordination problems arise when it may be optimal for both firms to reduce prices. Hence prices can be sticky simply because people expect them to be, even though stickiness is in no ones interest.
New Keynesian economics offers theories of why markets fail that are based on firm microfoundations and rational expectations. This school strengthens the case for activisim in demand management since sticky prices imply that variations in demand are reflected in variations in output. New Keynesians also suggest a role for the government on the supply side. For example, Efficiency Wage Theory showed that increases in taxation or reductions in unemployment benefit would reduce the equilibrium level of involuntary unemployment.
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