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Williamson_3e_IM_12 - Chapter 12 Keynesian Business Cycle...

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Chapter 12 Keynesian Business Cycle Theory: Sticky Wages and Prices Teaching Goals This chapter is the first in the text to seriously consider the possibility that the economy may not reach a competitive equilibrium. Failure to obtain a competitive equilibrium precludes any likelihood of achieving a Pareto optimal allocation. The first key point is to identify why the economy may fail to reach a competitive equilibrium. The analysis follows up on the failure of the nominal wage to immediately adjust in response to disturbances in the economy. The other principle source of such a failure would be the failure of nominal goods prices to adjust to disturbances. While the consequences are quite similar, the emphasis of this chapter is on the consequences of sticky nominal wages. The next step is to fully understand how such a possibly hypothetical economy would perform. That is, what are the effects of exogenous disturbances in a sticky wage economy? Mastery of the material in this chapter therefore requires an ability to analyze the effects of all of the usual sources of disturbances, just as students have done with the material in earlier chapters. This work is preliminary to answering two key questions. First, can a Keynesian sticky wage model account for the features of business cycles? On this point, the evidence is not very encouraging. Although the Keynesian sticky wage model fits some of the facts about business cycles, there are other properties of the typical business cycle that are seriously in conflict with the predictions of the model. The second key question is whether there is any role for government policy to restore a Pareto optimal competitive equilibrium when nominal wages are sticky. In this regard, the analysis presents a more optimistic viewpoint. Changes in the money supply can restore the same Pareto optimal allocation that would emerge if wages were fully flexible. Changes in fiscal policy can restore a Pareto optimum, although the particular allocation is not the same as the one that would be achieved by the appropriate change in the wage rate that would allow the labor market to clear. There is a sense in which one may view the effort to exhaustively investigate policy experiments in light of the Keynesian sticky wage model’s failure to satisfactorily explain the original phenomena of the business cycle as misguided. However, Keynesian macroeconomists maintain that the actual workings of the economy are much more complex than the workings of any reasonably simple economic model. Therefore, failure of the model to adequately explain all of the characteristics of business cycles is not that important. Keynesians have considerable faith in the model’s realistic portrayal of the effects of policy in real-world applications.
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