7.MyNotes - Economics Midterm 2 Review Chapter 12:...

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Economics Midterm 2 Review Chapter 12: Keynesian Business Cycle Like the classical economists, Keynesians recognize that real shocks contribute to the business cycle and that the public’s forecasts of various economic variables are based on reasoned and intelligent examination of available economic data However, they are less optimistic about the ability of free-market economies to respond quickly and efficiently to nominal price shocks One of their central ideas is that wages and prices are “rigid” and “sticky” and do not adjust quickly to market-clearing levels Therefore, nominal price shocks play a bigger role in the Keynesian model, thus more likely to use stabilization policies Criticisms of the Nominal Wage Rigidity Assumption Many economists object to relying so heavily on the assumption of nominal- wage stickiness to explain business cycles One objection is that less than 1/3 of the labour force in Canada is unionized and covered by labour contracts A second objection is that some labour contracts contain cost-of-living adjustments, which tie the nominal wage to the overall price level Today most contracts are not 100% indexed. Ex. 50 indexation, if the price level increase by 6%, the nominal wage increases by 3%, and real wage falls by 3% The reduction in the real wage induces firms to increase employment and production and therefore with partial indexation, in the SRAS curve slopes upward Why would firms and employees not always negotiate COLA clauses with complete indexation? (1) Employees and firms have different ideas of what is appropriate real wage. Firms calculate the real wage as the nominal wage they pay their workers relative to the price of their own output. Employees define the real wage that is relevant to them as the nominal-wage they receive relative to the general price level (2) Unless the rate of increase in the firm’s price and the general price level are expected to be the same during the period of the wage contract, partial indexation
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7.MyNotes - Economics Midterm 2 Review Chapter 12:...

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