Macroeconomics Tenth Edition, Global Edition

Macroeconomics

Tenth Edition, Global Edition

Chapter 11

Keynesianism: The Macroeconomics

of Wage and Price Rigidity

Learning Objectives

11.1 Summarize the Keynesian explanations for real–wage

rigidity (Sec. 11.1: Real–Wage Rigidity)

11.2 Describe the causes and effects of price stickiness

according to the Keynesian model (Sec. 11.2: Price

Stickiness)

11.3 Analyze the effects of monetary and fiscal policy in

the Keynesian model (Sec. 11.3: Monetary and Fiscal

Policy in the Keynesian Model)

11.4 Explain Keynesian theories about business cycles

and macroeconomic stabilization (Sec. 11.4: The

Keynesian Theory of Business Cycles and

Macroeconomic Stabilization)

•Wage rigidity is important in explaining unemployment

–In the classical model, unemployment is due to

mismatches between workers and firms

–Keynesians are skeptical, believing that recessions

lead to substantial cyclical employment

–Keynesians view equilibrium as a situation in which

there is no upward or downward pressure on wages

–To get a m o d e l in w hich unem p loyment pers ists ,

Keynesian theory posits that the real wage is slow to

adjust to equilibrate the labor market

Real–Wage Rigidity

•Some reasons for real–wage rigidity

–For unemployment to exist, the real wage must exceed the

market–clearing wage

–If the real wage is too high, why don’t firms reduce the

wage?

§One possibility is that the minimum wage and labor

unions prevent wages from being reduced

–But most U.S. workers are not minimum wage

workers, nor are they in unions

–The minimum wage would explain why the nominal

wage is rigid, but not why the real wage is rigid

–This might be a better explanation in Europe, where

unions are far more powerful

Real–Wage Rigidity

•Some reasons for real–wage rigidity

–If the real wage is too high, why don’t firms reduce the

wage?

§Another possibility is that a firm may want to pay

high wages to get a stable labor force and avoid

turnover costs—costs of hiring and training new

workers

§A third reason is that workers‘ productivity may

depend on the wages they‘re paid—the efficiency

wage model

Real–Wage Rigidity

•The Efficiency Wage Model

–Workers who feel well treated will work harder and

more efficiently (the “carrot“); this is Akerlof’s gift

exchange motive

–Workers who are well paid will not risk losing their jobs

by shirking (the “stick”)

–Both the gift exchange motive and shirking model imply

that a worker‘s effort depends on the real wage

Real–Wage Rigidity

Determination of the Efficiency Wage

•The Efficiency Wage Model

–The effort curve, plotting effort

against the real wage, is S–

shaped

§At low levels of the real

wage, workers make hardly

any effort

§Effort rises as the real wage

increases

§As the real wage becomes

very high, effort flattens out

as it reaches the maximum

possible level

Determination of the Efficiency Wage

•Wage determination in the

efficiency wage model

–To maximiz e p r o f i t , f i r m s

choose the real wage that

gets the most effort from

workers for each dollar of real

wages paid

–This occurs at point B, where

a line from the origin is just

tangent to the effort curve

–The wage rate at point Bis

called the efficiency wage

–The real wage is rigid as long

as the effort curve does not

change

•Employment and Unemployment in the

Efficiency Wage Model

–The labor market determines

employment and unemployment,

depending on how far above the

market–clearing wage is the

efficiency wage

–The labor supply curve is upward

sloping, while the labor demand

curve is the MPN when the effort

level is determined by the efficiency

wage

–The difference between labor supply

and labor demand is the amount of

unemployment

–The fact that there is unemployment

puts no downward pressure on the

real wage, since firms know that if

they reduce the real wage, effort will

decline

Real–Wage Rigidity

•Employment and Unemployment in the Efficiency Wage

Model

–Does the efficiency wage theory match up with the

data?

–It seems to have worked for Henry Ford in 1914

–Plants that pay higher wages appear to experience less

shirking

–But the theory implies that the real wage is completely

rigid, whereas the data suggests that the real wage

moves over time and over the business cycle

Real–Wage Rigidity

•Employment and Unemployment in the Efficiency Wage

Model

–It is possible to jazz up the model to allow for the

efficiency wage to change over time

§Workers would be less likely to shirk and would work

harder during a recession if the probability of losing

their jobs increased

§This would cause the effort curve to rise and may

cause the efficiency wage to decline somewhat

§This would lead to a lower real wage rate in

recessions, which is consistent with the data

Real–Wage Rigidity

•Efficiency wages and the FE line

–The FE line is vertical, as in the classical model, since

full–employment output is determined in the labor

market and does not depend on the real interest rate

Real–Wage Rigidity