Question

In Laurence Meyer’s “Monetarism Without Money” model, there are “backward-looking” elements in his equations (1) and (2) so that last period’s level of the output gap and last period’s rate of inflation affect this period’s output gap and inflation rate. This is to capture the role of sticky wages and prices in the short run. Here he must really be talking about sticky rates of change of wages and prices. How does this allow a role for monetary policy, and how does monetary policy work in his model? We ought to be able to apply the New Keynesian explanations of sticky wages and prices to explain the existence of “backward-looking” influences. How do the New Keynesians argue that explicit and implicit contracts and efficiency wages slow down changes in money and real wages? Why did John Maynard Keynes say, though, that sticky wages and prices are not necessary to explain unemployment?

Answer 1

The model includes an aggregate demand equation, a Phillips curve, and a monetary policy rule. The aggregate demand equation, given by equation 1, is essentially a dynamic version of the old IS curve, in which the level of output (in this case the output gap) depends on the real interest rate. This specification allows for effects of both lagged output and expectations about future output. The Phillips curve, given by equation 2, relates the inflation rate to the output gap (measuring the balance between supply and demand in the output market) and to both past inflation and inflation expectations. The effect of past inflation captures the role of sticky prices, while inflation expectations are assumed to be set, as in equation 1, according to rational expectations. The policy rule, equation 3, relates the interest rate, viewed as the instrument of monetary policy, to the output gap and the difference between inflation and the central bank's inflation target. That is, policy is adjusted in response to the deviations of output and inflation from their respective objectives – full employment and price stability. There are at least three innovations in the consensus model compared with the IS-LM framework, perhaps yesterday's consensus model. First, the IS-LM model had two equations and three unknowns and therefore could be solved only by assuming that either the price level or the output level was fixed. Today's consensus model allows for both sticky prices in the short run and full price flexibility in the long run by introducing the Phillips curve. In effect, the Phillips curve pins down the degree to which prices are sticky in the short run, allowing scope for both short-run movements in actual output relative to potential and for stabilization policy while providing a mechanism that ensures a transition to the long-run classical equilibrium.

There is clearly much nominal wage rigidity in actual economies-in U.S. labor contracts, for example, wages are set up to three years in advance-the allocative effects of this rigidity are unclear. The implicit contracts literature shows that it may be efficient for contract signers to make employment independent of wages. That is, given long-term relationships with their workers, firms may choose the efficient amount of employment rather than moving along their labor demand curves when real wages change. In many product markets, on the other hand, buyers clearly operate on their demand curves. For example, the local shoe store has no agreement, explicit or implict, from its customers to buy the efficient number of shoes regardless of the prices. Instead, rigidity in the store's prices affects its sales of shoes.

Keynes expressed that wages were “sticky” in terms of money. He noted, for example, that workers and unions tended to fight tooth-and-nail against any attempts by employers to reduce money wages (the actual sum of money workers receive, as opposed to the real purchasing power of these wages, taking account of changes in the cost of living), even by a little bit, in a way they did not fight for increases in wages every time there was a small rise in the cost of living eroding their “real wages.” Keynes argued emphatically, however, against the idea that the stickiness of money wages was the cause of unemployment, or that full flexibility of money wages (in particular, a decline in money wages) was likely to be a cure for depressions.