In the most recent updating of the Handbook of Monetary Economics, Greg Mankiw and Ricardo Reis (2010, p.222) are thoroughly New Keynesian in how they frame the question of why money matters. The framing restricts, and ultimately defeats, an adequate answer: “Since the birth of business cycle theory, economists have struggled with one overarching question: What is the nature of the market imperfection, if any, that causes the economy to deviate in the short run from full employment and the optimal allocation of resources? Or, to put the question more concretely and more prosaically in terms of undergraduate macroeconomics: What friction causes the short-run aggregate supply curve to be upward sloping rather than vertical, giving a role to aggregate demand in explaining economic fluctuations?”
An adequate answer to why money matters turns out to be inconsistent with modern theorists’ consensus assumption, illustrated by Mankiw-Reis, that optimizing exchange occurs wholly in the marketplace. That universal, unexamined, and ultimately untenable belief implies that the channel through which nominal disturbances induce deviations from full employment must be rooted in one or more market frictions. The problem is that candidate frictions must confront, and are always dominated by, rational employer offers to cut wages in lieu of job loss. If the reduction does not violate employee opportunity costs, it is accepted. If it does violate opportunity costs, the worker quits; and the job separation is voluntary.
Wage recontracting provides a stonewall market-centric DSGE defense against the failure to realize gains from trade that cannot be ignored in coherent continuous-equilibrium macro modeling. Yet, it has become clear that recontracting, and consequently model coherence, must be ignored if market-centric thinking is to be stabilization-relevant. That New Keynesian conundrum plagues much of the modeling featured in the monetary-economics Handbook. Meaningful wage rigidity (MWR) is necessary for the existence of involuntary job loss but cannot itself exist in coherent market-centric DSGE thinking. (Chapter 1) The mainstream response to that macro muddle has been to construct and use models that push aside the rational treatment of wages. The discomfiting, ostrich-like strategy obscures the conundrum and its debilitating effects on modern efforts to derive operational stabilization theorems.
Jordi Gali (2010), burdened with a topic (monetary policy and unemployment) that affords little place to hide, provides the only modeling of nominal wage rigidity in the fifteen hundred pages of the Handbook. It is not surprising that his market-centric treatment amounts to little more than drawing attention to, first, the cyclical behavior that has been squeezed out of voluntary joblessness by S/M/B theorists and, second, the practice of positing restrictions, usually of the Calvo (1983) variety, on the incidence of wage recontracting. Both strategies are obvious failures.
When applied to the core macro problem of instability in highly specialized economies, S/M/B modeling is doomed from the start. Everybody knows that the approach cannot accommodate involuntary job loss, implying endogenous cyclicality must be sufficiently mild never to generate employment separation that is forced – i.e., recognizable layoffs. Nor does Gali confront the methodological requirement (designed in part to weed out convenient implausibilities) that continuous-equilibrium modeling derive its significant restrictions from model primitives. The policy-relevant findings reported in his article wholly result from free parameters that ultimately differ little from those used by the Early Keynesians. Of course, that criticism is rooted in Gali having done what the Handbook promises, a survey of contemporary thinking. His inattention to the crucial issues of labor pricing accurately portrays the outsider status of wage rigidities, once recognized as the centerpiece of macro theory, in the modern New Keynesian mainstream.
The alternative to simply ignoring the most pressing problems in monetary theory is to get serious about modeling meaningful wage rigidity. It should be encouraging that the necessary content of any such effort has been understood by practitioners for a long time. During the century and a half since the Second Industrial Revolution, rational workplace exchange has suppressed wage recontracting for an ever-increasing share of the global labor force. MWR, formally derived, implies that in large establishments labor-market opportunity costs are chronically and variably below labor’s marginal value product. Chronic continuous-equilibrium wage rents push workers off their notional market-supply schedule, thwarting optimization at the leisure-consumption margin. In large, complex workplaces, employees instead optimize their discretionary on-the-job behavior in response to axiomatic preferences. It is good news that recognition of such preferences and conduct that rationally pursues them is today being forced into mainstream macro theory by behavioral economists.
MWR uniquely microfounds the macro channel that, when combined with sufficiently adverse shifts in nominal demand, induces recognizable recession-sized jumps in involuntary job loss, an outcome that aligns with critical cyclical evidence. We will know the macroeconomics has returned to a more productive path when a future edition of the monetary Handbook returns to featuring wage rigidities.
Blog Type: New Keynesians Saint Joseph, Michigan