“New and Old Keynesians,” Greenwald and Stiglitz

This article discusses the main criticism of all equilibrium models, that no matter how well designed the model or elegant the argument, markets do not always clear. The recurring themes of risk averse firms, and ineffective monetary policy are considered, but Greenwald and Stiglitz turn to the labor market and attempt to explain sticky real wages. Assuming that there are people who are willing to work at the going wage but are unable to find work, that is, involuntary unemployment does exist, they look at efficiency wages, insider-outsider theory, imperfect competition, and implicit contracts.
Efficiency wage theory says that productivity increases with real wages, so it doesn’t pay for a firm to cut wages. Insider-outsider theory looks at training and turnover costs. Since the insiders will be training the outsiders, they will not be happy about teaching new people to take over their own jobs at lower wages. Even if that were to happen, given imperfect competition, there could be reductions in the quality and effort of labor, and nothing says the new cheap labor won’t demand higher wages once they’re hired and trained. Thus, a firm could find itself with a more expensive and less productive labor force than it started with. That’s the supply side of labor. On the demand side, the question is why there are large fluctuations in the employment rate and only small variations in real product wages. With given technology and capital stock, if firms operate along their supply function, a reduction in output should be associated with an increase in real product wages, but that is not what happens. Greenwald and Stiglitz believe this has to do with risk averse firms. When an economy goes into recession, aggregate supply shifts to the left. This can also be depicted by a shift in aggregate demand for labor. Firms are more likely to layoff several workers than to reduce the hours of everyone in their workforce, which would be more beneficial to the workforce and the economy as a whole. Mankiw made a similar comment in his article titled “New Keynesian Economics,” saying firms were more willing to lay off workers during a recession because there were no other jobs to be found and the same people could be rehired when they were needed again. That is, firms are saving money when they need it and are risking very little with layoffs.
The Journal of Economic Perspectives, Vol. 7, No. 1 (Winter, 1993), pp. 23-44.