Explain for Which Reasons the Real Wage Is Expected to Be Acyclical in the Classical Model, Countercyclical in the Keynesian Model and Procyclical in the New Keynesian Model. Which Model Better Fits the Empirical Evidence?
Explain for which reasons the real wage is expected to be acyclical in the classical model, countercyclical in The Keynesian Model and Procyclical in the New Keynesian model. Which model better fits the empirical evidence?
Introduction
The concept of real wages has increasing significance in the current world. Rising inflation and recession in almost all major economies have led to the importance of studying real wage with respect to prices and economies themselves. Such a study would require an in-depth understanding of the business cycle of real wages. From Classical theory to New Keynesian theory, Cyclicality of real wage has been defined in contrasting terms. Much of the conflicting evidence is simply characteristic of empirical research. Researchers use different model specifications and estimation techniques. Empirical results are often sensitive to the choice of cyclical indicators and time period chosen (Dimelis, 2007).
This essay seeks to explain why real wage is expected to be acyclical in the classical model, counter-cyclical in the Keynesian model and procyclical in the New Keynesian model and shed light on which model best fits empirical evidence.
Real Wage
Real wage is defined as the “wage paid to the average worker divided by the price level.”(Delong and Olney,2006 p.535) It therefore measures the cost of labour in real terms as it is the number of units of output that can be exchanged for one time-based unit of work.(Levacic and Rebmann, 1982)
The Classical Model
In the classical model, the basic assumption is that prices and wages are flexible. The basis of classical theory is that the markets work perfectly, that prices adjust rapidly to cover any gap that may arise due to a difference in the quantities demanded and supplied. (Delong and Olney,2006)
The classical model thus assumes full employment, i.e. the actual output matches the potential output of the economy. Since prices are flexible, an increase in the supply of labour
Introduction
The concept of real wages has increasing significance in the current world. Rising inflation and recession in almost all major economies have led to the importance of studying real wage with respect to prices and economies themselves. Such a study would require an in-depth understanding of the business cycle of real wages. From Classical theory to New Keynesian theory, Cyclicality of real wage has been defined in contrasting terms. Much of the conflicting evidence is simply characteristic of empirical research. Researchers use different model specifications and estimation techniques. Empirical results are often sensitive to the choice of cyclical indicators and time period chosen (Dimelis, 2007).
This essay seeks to explain why real wage is expected to be acyclical in the classical model, counter-cyclical in the Keynesian model and procyclical in the New Keynesian model and shed light on which model best fits empirical evidence.
Real Wage
Real wage is defined as the “wage paid to the average worker divided by the price level.”(Delong and Olney,2006 p.535) It therefore measures the cost of labour in real terms as it is the number of units of output that can be exchanged for one time-based unit of work.(Levacic and Rebmann, 1982)
The Classical Model
In the classical model, the basic assumption is that prices and wages are flexible. The basis of classical theory is that the markets work perfectly, that prices adjust rapidly to cover any gap that may arise due to a difference in the quantities demanded and supplied. (Delong and Olney,2006)
The classical model thus assumes full employment, i.e. the actual output matches the potential output of the economy. Since prices are flexible, an increase in the supply of labour
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