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10. keynesian economics - Keynesian Macroeconomics Price...

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Keynesian Macroeconomics: Price and Wage Rigidity 28 October 2010 1 Reading Chapter 11 of Abel/Bernanke/Croushore 2 Real—Wage Rigidity: E ciency Wage Theory In this lecture, our focus is exclusively on Keynesian macroeconomics (KE), the de fi ning characteristic of which is the presumption that prices and wages are rigid, at least in the short run. We should go beyond simply assuming rigidities and exploring the consequences thereof, but also study the microeconomics un- derlying them. This sets our analysis apart from old fashion Keynesian macro- economics which simply asserts that prices and wages are rigid. This more recent strand of Keynesian macroeconomics is often known as New Keynesian macroeconomics. We start with real—wage rigidity. Proponents of KE assert that the major fault with NCM, with its assumption of market clearing, is that it is inconsistent with how unemployment can exist. Keynesian economists reasoned that the existence of unemployment was evidence cast in stone that the real wage must be rigid downward. The research question was to understand forces that prevent the real wage from falling to the market—clearing level. One prominent theory, due to Nobel Laureate Joseph Stiglitz, is the e ciency wage theory. The analysis starts with presumption that no worker would bother to exert e ff ort to work if there are no penalties for shirking. This necessitates monitoring on the part of fi rms; if fi rms want to see their workers put in any e ff ort at all, the workers have to be monitored and penalized when they are caught shirking. If the labor market indeed clears, whenever a worker shirks and is caught and dismissed, he should be able to fi nd another job almost instantaneously at the same wage at which he is currently paid since labor 1
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Figure 1: Unemployment and downward—rigid real wage demand and supply are just equal. Then there can be no penalty for shirking and no one would exert e ff ort at all. When no e ff ort is exerted, the worker is of no use to his employer. A wage equal to the market—clearing level cannot be equilibrium because at this wage, workers shirk and fi rms would not fi nd it useful to hire shirking workers. If the prevailing wage rate is equal to the market—clearing level, and employment is equal to full employment, an individual fi rm would have incentives to pay a wage somewhat above the prevailing market wage. When the fi rm pays a somewhat higher wage than others, and when a worker of the fi rm is caught shirking and dismissed, any alternative employment opportunities only pay the worker a lower wage. The worker thus faces a real cost for shirking, equal to the decline in wage times the probability that he is caught shirking. If the expected cost of shirking is above the cost of exerting e ff orts, the worker will choose not to shirk.
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