Question

Note the three basic ingredients of “market imperfection” New Keynesianism and discuss the Macro consequences of each. Give an example of how flexible prices combined with one of these market imperfections can lead a shock creating movements away from full-employment equilibrium.

Answer 1

New Keynesianism uses micro economics foundations to explain the macro economics issues. Following market failures occurs:

• Wage stickiness.: Wage stickiness implies the wage rate does not fall during the recession. Hence, employers are not ready to recruit more workers. Hence, it causes widespread unemployment rate.
• Inflexible price level: Price does not adjust according to demand and supply, hence demand does not rise which result into further deepening of recession.
• Coordination failure.: if workers are hired by factor owners, these workers would automatically increase demand. But there is lack of coordination between owners and workers which brings about recession.

Wage rigidity along with the price inflexibility are supreme examples of market imperfections. Wage rate does not fall during the recession due to imperfections in labor market. Hence, recession can not be tackled by the market forces. Government must intervene in economic activities to deal with such market imperfections. Market system along can not solve issue of recession.