Question

1. Explain Keynes’ argument that “sticky wages and other prices can cause a recession.

Answer 1

Keynesian economics focuses on explaining why recessions and depressions occur and offering a policy prescription for minimizing their effects. The Keynesian view of recession is based on two key building blocks.

First, aggregate demand is not always automatically high enough to provide firms with an incentive to hire enough workers to reach full employment.

Second, the macroeconomy may adjust only slowly to shifts in aggregate demand because of sticky wages and prices, which are wages and prices that do not respond to decreases or increases in demand.

The first building block of the Keynesian diagnosis is that recessions occur when the level of household and
business sector demand for goods and services is less than what is produced when labor is fully employed. In
other words, the intersection of aggregate supply and aggregate demand occurs at a level of output less than the level of GDP consistent with full employment.

As Keynes recognized, the events of the Depression contradicted Say's law that "supply creates its own demand."Although production capacity existed, the markets were not able to sell their products. As a result, real GDP was less than potential GDP.

Keynes emphasized one particular reason why wages were sticky: the coordination argument.This argument points out that, even if most people would be willing at least hypothetically to see a decline in their own wages in bad economic times as long as everyone else also experienced such a decline, a market-oriented
economy has no obvious way to implement a plan of coordinated wage reductions.

Unemployment proposed a number of reasons why wages might be sticky downward, most of which center on the argument that businesses avoid wage cuts because they may in one way or another depress morale and hurt the productivity of the existing workers. Some modern economists have argued in a Keynesian spirit that, along with wages, other prices may be sticky, too.