FIGURE 5.11 The labor market with sticky wages, flexible prices, and a competitive goods market

real wage, and a fall in employment. This is shown as Point E in the diagram. This view of aggregate supply therefore implies a countercyclical real wage in response to aggregate demand shocks. This prediction has been subject to extensive testing beginning shortly after the publication of the General Theory. It has found little support: most studies have found that the real wage is approximately acychcal, or moderately procyclical.

Case 2: Sticky Prices, Flexible Wages, and a Competitive Labor Market

The view of aggregate supply in the General Theory assumes that the goods market is competitive and goods prices are completely flexible, and that the source of nominal stickiness is entirely in the labor market. This raises

"Studies of the cyclical behavior of the real wage were pioneered by Dunlop (1938) and Tarshis (1939). These papers have spawned a vast literature. See, for example, Geary and Kennan (1982); Bils (1985); Keane, Moffitt, and Runlde (1988); Beaudry and DiNardo (1991); and Solon, Barsky, and Parker (1994).

In his important paper responding to Dunlops and Tarshiss studies, Keynes (1939) largely disavowed the specific formulation of aggregate supply in the General Theory, saying that he had chosen it to keep the model as classical as possible and to simplify the presentation. His 1939 view of aggregate supply is closer to Case 4, below.

) > 0. (5.28)

As before, employment and output are related by the production function, Y = F{L) (equation [5.25]). Finally, firms meet demand at the prevaihng price as long as it does not exceed the level where margmal cost equals price; we let denote this level of output.

With these strong assumptions about price rigidity, the aggregate supply curve is not just nonvertical, but horizontal. Specifically, it is a horizontal

An important exception to the usual pairmg of incomplete price adjustment with imperfect competition is found m the disequilibrium literature. These models typically assume a competitive goods market, and they consider the possibility of rationing by hrms. In addi-Uon, the models typically have wage rigidity as well as price rigidity and allow for rationing (of either workers or firms) m the labor market. See, for example, Barro and Grossman (1971); Solow and Stightz (1968); and Malinvaud (1977). Benassy (1976) extends disequilibrium models to imperfect competition.

"Note that by writing labor supply as a function only of the real wage, we are ignoring the intertemporal-substitution and interest-rate effects that are central to employment fluctuations in real-busmess-cycle models. In principle these effects can be incorporated into the model. The prevailing view among Keynesians, however, is that these effects are not large. Thus, following the general modeling strategy described m Section 5.1, they are usually simply omitted.

the question of what occurs in the reverse case where the labor market is competitive and wages are completely flexible, and where the source of incomplete nominal adjustment is entirely in the goods market.

The assumption that goods prices are not completely flexible is almost always coupled with the assumption that there is imperfect competition in the goods market. This is done for two reasons. First, with perfect competition, at the flexible-price equilibrium firms are selling the amount they want. A rise in demand from its initial level with prices unchanged therefore causes them to ration buyers. With imperfect competition, in contrast, price exceeds marginal cost and firms are better off if they can sell more at the prevailing price. It is therefore reasonable to assume that if prices do not adjust, then over some range firms are willing to produce to satisfy demand.

Second, the eventual goal of the theory is to derive rather than assume incomplete price adjustment. To do this, it is better to have price-setters (such as the firms in a model with imperfect competition) than an outside actor who sets prices (such as the Walrasian auctioneer of competitive mod-els).i4

With this view, prices rather than wages are assumed rigid:

P = P. (5.27)

Wages are flexible; thus workers are on their labor supply curve, which is assumed to be upward-sloping:

FIGURE 5.12 Aggregate supply with rigid goods prices

line at P out to . jjjjg jg shown in Figure 5.12. Fluctuations in aggregate demand cause firms to change employment and output at the fixed price level, P. And if aggregate demand ever becomes so large that demand al P exceeds y, output equals and firms ration sales of their goods.

Figure 5.13 shows this models implications for the labor market. Firms demand for labor is determined by their desire to meet the demand for their goods. Thus-as long as the real wage is not so high that it is unprofitable to meet the full demand-the labor demand curve is a vertical line in employment-wage space. The term effective labor demand is used to describe a situation, such as this, where the quantity of labor demanded depends on the amount of goods that firms are able to sell. The real wage is determined by the intersection of the effective labor demand curve and the labor supply curve (Point E). Thus workers are on their labor supply curve and there is no unemployment.

This model implies a procyclical real wage in the face of demand fluctuations. A fall in aggregate demand, for example, leads to a fall in effective labor demand, and thus to a fall in the real wage as workers move down their

If the real wage is so high that it is not profitable for firms to meet the demand for their goods, the quantity of labor demanded is determined by the condition that the marginal product equals the real wage. Thus this portion of the labor demand curve is downward-sloping. /