Chapter 11
Keynesianism: The Macroeconomics
of Wage and Price Rigidity
Learning Objectives
1. In the classical model, unemployment is due to mismatches between workers and firms
2. Keynesians are skeptical, believing that recessions lead to substantial cyclical unemployment
3. To get a model in which unemployment persists, Keynesian theory posits that the real wage
is slow to adjust to equilibrate the labor market
1. For unemployment to exist, the real wage must exceed the market-clearing wage
2. If the real wage is too high, why don’t firms reduce the wage?
a. One possibility is that the minimum wage and labor unions prevent wages from being
reduced
(1) But most U.S. workers aren’t minimum wage workers, nor are they in unions
(2) The minimum wage would explain why the nominal wage is rigid, but not why the
real wage is rigid
(3) This might be a better explanation in Europe, where unions are far more powerful
b. 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
c. A third reason is that workers’ productivity may depend on the wages they’re paid—the
efficiency wage model
C. The Efficiency Wage Model
1. Workers who feel well treated will work harder and more efficiently (the “carrot”); this is
Akerlof’s gift exchange motive
2. Workers who are well paid won’t risk losing their jobs by shirking (the “stick”)
3. Both the gift exchange motive and shirking model imply that a worker’s effort depends on
the real wage (Figure 11.1)
4. The effort curve, plotting effort against the real wage, is S-shaped
a. At low levels of the real wage, workers make hardly any effort
1. Given the effort curve, what determines the real wage firms will pay?
2. To maximize profit, firms choose the real wage that gets the most effort from workers for
each dollar of real wages paid
3. This occurs at point B in Figure 11.1, where a line from the origin is just tangent to the effort
curve
4. The wage rate at point B is called the efficiency wage
5. The real wage is rigid, as long as the effort curve doesn’t change
E. Employment and Unemployment in the Efficiency Wage Model
1. The labor market now determines employment and unemployment, depending on how far
above the market-clearing wage is the efficiency wage (Figure 11.2)
2. The labor supply curve is upward sloping, while the labor demand curve is the marginal
product of labor when the effort level is determined by the efficiency wage
3. The difference between labor supply and labor demand is the amount of unemployment
4. The fact that there’s unemployment puts no downward pressure on the real wage, since firms
know that if they reduce the real wage, effort will decline
5. Does the efficiency wage theory match up with the data?
a. It seems to have worked for Henry Ford in 1914
b. Plants that pay higher wages appear to experience less shirking
c. 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
1. The FE line is vertical, as in the classical model, since full-employment output is determined
in the labor market and doesn’t depend on the real interest rate
2. But in the Keynesian model, changes in labor supply don’t affect the FE line, since they
don’t affect equilibrium employment
3. A change in productivity does affect the FE line, since it affects labor demand
Numerical Problem 1 looks at the determination of the efficiency wage and employment.
1. The data suggest that money is not neutral, so Keynesians reject the classical model
(without misperceptions)
2. Keynesians developed the idea of price stickiness to explain why money isn’t neutral
3. An alternative version of the Keynesian model (discussed in Appendix 11.A) assumes that
nominal wages are sticky, rather than prices; that model also suggests that money isn’t
neutral
Theoretical Application
The idea that nominal wage contracts lead to a fixed nominal wage in a theoretical Keynesian
1. Monopolistic competition
a. If markets had perfect competition, the market would force prices to adjust rapidly; sellers
are price takers, because they must accept the market price
b. In many markets, sellers have some degree of monopoly; they are price setters under
monopolistic competition
Theoretical Application
The major articles underlying Keynesian theory are collected in the volume New Keynesian
Economics, edited by N. Gregory Mankiw and David Romer, Cambridge, Massachusetts: MIT
Press, 1991. The main topics covered are costly price adjustment, the staggering of wages and
prices, imperfect competition, coordination failures, the labor market, the credit market, and the
goods market.
1. Workers who feel well treated will work harder and more efficiently (the “carrot”); this is
Akerlof’s gift exchange motive
2. Workers who are well paid won’t risk losing their jobs by shirking (the “stick”)
3. Both the gift exchange motive and shirking model imply that a worker’s effort depends on
the real wage (Figure 11.1)
4. The effort curve, plotting effort against the real wage, is S-shaped
a. At low levels of the real wage, workers make hardly any effort
1. Given the effort curve, what determines the real wage firms will pay?
2. To maximize profit, firms choose the real wage that gets the most effort from workers for
each dollar of real wages paid
3. This occurs at point B in Figure 11.1, where a line from the origin is just tangent to the effort
curve
4. The wage rate at point B is called the efficiency wage
5. The real wage is rigid, as long as the effort curve doesn’t change
E. Employment and Unemployment in the Efficiency Wage Model
1. The labor market now determines employment and unemployment, depending on how far
above the market-clearing wage is the efficiency wage (Figure 11.2)
2. The labor supply curve is upward sloping, while the labor demand curve is the marginal
product of labor when the effort level is determined by the efficiency wage
3. The difference between labor supply and labor demand is the amount of unemployment
4. The fact that there’s unemployment puts no downward pressure on the real wage, since firms
know that if they reduce the real wage, effort will decline
5. Does the efficiency wage theory match up with the data?
a. It seems to have worked for Henry Ford in 1914
b. Plants that pay higher wages appear to experience less shirking
c. 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
1. The FE line is vertical, as in the classical model, since full-employment output is determined
in the labor market and doesn’t depend on the real interest rate
2. But in the Keynesian model, changes in labor supply don’t affect the FE line, since they
don’t affect equilibrium employment
3. A change in productivity does affect the FE line, since it affects labor demand
Numerical Problem 1 looks at the determination of the efficiency wage and employment.
1. The data suggest that money is not neutral, so Keynesians reject the classical model
(without misperceptions)
2. Keynesians developed the idea of price stickiness to explain why money isn’t neutral
3. An alternative version of the Keynesian model (discussed in Appendix 11.A) assumes that
nominal wages are sticky, rather than prices; that model also suggests that money isn’t
neutral
Theoretical Application
The idea that nominal wage contracts lead to a fixed nominal wage in a theoretical Keynesian
1. Monopolistic competition
a. If markets had perfect competition, the market would force prices to adjust rapidly; sellers
are price takers, because they must accept the market price
b. In many markets, sellers have some degree of monopoly; they are price setters under
monopolistic competition
Theoretical Application
The major articles underlying Keynesian theory are collected in the volume New Keynesian
Economics, edited by N. Gregory Mankiw and David Romer, Cambridge, Massachusetts: MIT
Press, 1991. The main topics covered are costly price adjustment, the staggering of wages and
prices, imperfect competition, coordination failures, the labor market, the credit market, and the
goods market.