8 - Macroeconomic Adjustment and Keynes’s Instability Argument

Summary

Keynesian involuntary unemployment describes a market failure: market forces may be incapable of bringing the economy to full employment. Wage and price stickiness are not the problem. Keynes took prices to be flexible and viewed sticky nominal wages as desirable: flexibility would tend to make the economy violently unstable. The IS-LM model provides a decent representation of the analytical skeleton behind Keynes’s fix-wage equilibrium but leaves out dynamic forces that are central to Keynes’s instability argument. By including one of these forces – the effects of expected inflation on real interest rates – in a formal model, Tobin showed that wage flexibility does not ensure the stability of full employment. The model’s assumption of an exogenous money supply misrepresents the real-world behavior of central banks as well as contemporary theory. Introducing a Taylor rule, stability can be obtained if the zero lower bound does not constrain interest rates – a result anticipated by Keynes: “only a foolish person would prefer a flexible wage policy to a flexible monetary policy”, he argued, while warning about the ineffectiveness of the policy in a liquidity trap.