In the most important contribution to the fixed-wage general-equilibrium (FWGE) literature, Robert Barro and Herschel Grossman (1971), hereafter B&G, posit nominal wage rigidity in order to investigate the interdependence of rationing in the labor and goods markets. Such analysis must be general; partial-equilibrium labor-market analysis is inherently inadequate to the task. B&G identify several macro regimes, the applicability of each depending on which markets are experiencing excess demand or supply. GEM modeling is most compatible with their Keynesian regime, in which the labor market exhibits excess supply.
Most interesting about the B&G FWGE story is not that their model is one of the most insightful in the Keynesian literature, although it is. What really catches attention is that the authors publicly disowned the analysis around the same time that their FWGE book was published in 1976. By then, assuming nominal wage rigidity and, therefore, failing to rigorously apply market-centric general equilibrium modeling was becoming a mortal sin. New Classical and emerging RBC theorists insisted that the next stop for the powerful theory be the dustbin.
That judgement was rendered despite the model meeting the standards for good theory that was featured in last week’s post: “Like any good [theory], it provides an explanation for something that is previously unexplainable. Just as important, it makes predictions that can be tested.” It reveals a great deal about the “cultural revolution” nature of the macro wars that B&G agreed that their analysis was not acceptable macroeconomics.
FWGE modeling and Keynesian consumption. One of the achievements of the GEM Project of which I am most proud is its powerful enrichment and revival the original B&G fixed-wage general-equilibrium model. Generalized rational exchange microfounds their keystone assumption of wage rigidity. B&G used their insightful modeling to explore Clower’s interpretation of the Keynesian consumption function. In their contribution, the primary relation between income and consumer spending is a consequence of Walrasian disequilibrium in the labor market. Worker income, now representing the constrained effective demand for current output resulting from labor being in excess supply, centrally influences rational household consumption-saving choice.
Once firms rationally pay meaningfully rigid wages, job rationing is consistent with optimizing exchange anchored by continuous general decision-rule equilibrium. In that equilibrium, households cannot sell all the labor services that they prefer and, as a result, must adjust to restricted labor income.
The household optimization problem must now deal with the rational disposition of constrained income that makes consumption centrally dependent on labor income and wealth. From B&G (1971, p.88): “The important property … is that [effective demands] do have the form of the usual Keynesian consumption and saving functions. Labor income enters the consumption and saving functions as it represents the constraints upon the demand for current output imposed by the market excess supply of labor.”
Meanwhile, rationed rent-paying jobs forces market-sector employees to accept zero hours in high-wage jobs for which they are qualified, well below the quantity of higher-wage work they prefer. Their optimization problem is similarly reduced to the rational disposition of constrained income, which becomes the central determinant of their consumption decision. Putting the pieces together, FWGE modeling enriched with microfounded MWR provides a rational-behavior continuous-equilibrium interpretation of Keynesian income-driven consumption. Something important that was previously unexplainable is explained, contributing significantly to our understanding of stabilization-relevant effective demand.
Barro and microfounded MWR. As noted, Barro relatively quickly abandoned his FWGE analysis when anti-Keynesian insurgents challenged the ad hoc nature of his keystone wage rigidity. Thereafter, he has never wavered from his commitment to fully microfounded general market equilibrium. (Herschel Grossman died at a young age.) Barro has never been interested in research programs that sought MWR microfoundations, even at the cost of sweeping his best work into oblivion. It is curious that such a careful theorist was never interested in the fact of wage rigidity, never thinking through the implications for the pricing and use of labor in the highly specialized economies that evolved after the Second Industrial Revolution. He never indicated interest in the longstanding conclusion of microeconomics that wage determination restricted by employee-employer asymmetric information cannot efficiently occur in the labor market.
Had Barro recognized the power of generalizing optimizing exchange to information-restricted workplaces, he would have surely been interested in the unique capacity of meaningful wage rigidity to rationally suppress labor-price recontracting. He would have grasped the necessity of MWR in motivating causality from nominal demand disturbances to involuntary job loss and recognizable movement of total employment, output, and income. He surely would have grasped how his pioneering FWGE Keynesian modeling would be a comfortable fit in two-venue rational-behavior general-decision-rule-equilibrium modeling. His Nobel is still waiting to be picked up.
Blog Type: New Keynesians Chicago, Illinois