Chapter 2: Toward a general theory of wage and price rigidities and economic fluctuations
2. Toward a general theory of wage and price rigidities and economic fluctuations Joseph E. Stiglitz1 This chapter begins with the hypothesis that large economic fluctuations, the marked changes in the unemployment that characterize market economies, are a consequence of problems of adjustment to disturbances, especially adjustments of wages and prices. Two strands of work have addressed these problems of adjustment. One focuses on rigidities: downward rigidities in wages are at the center of traditional Keynesian models. The other focuses on the consequences of rapid changes, particularly in asset prices, in the context of markets with incomplete contracting (imperfect indexing) and imperfect capital markets. While the second tradition traces its origins at least back to Irving FisherÕs debt-deflation theories, it has been revived in the new-Keynesian work of Bruce Greenwald and Stiglitz (1988, 1989, 1990b, 1993, 1995) and others. The fact that wages and prices did fall dramatically in the Great Depression (by more than a third in the United States) provided some of the impetus to the latter theory. The major economic downturn this year in East Asia, with unemployment in Indonesia soaring from 4.7 percent to 14.3 percent and output falling by at least 16 percent, was accompanied by huge changes in prices: over the first year of the crisis, the current best estimate is that Indonesian real wages fell by 40Ð60 percent (World Bank, 1998, p. 105). This result, I would argue, is better interpreted through the second strand of thought. I. ASYMMETRIES IN ADJUSTMENT...
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