In times of economic uncertainty, why do wages and prices often remain ‘rigid,’ even as demand drastically falls or spikes? This phenomenon, known as ‘stickiness,’ is a central concept in Keynesian economics. The father of this section of economics, John Maynard Keynes, argued that without government intervention, mainly fiscal or monetary policies, the rigidity of prices can ’trap’ economies in high unemployment and slow growth cycles.

This article delves into why wages and prices are ‘sticky downwards’ and how government policies can address this challenge to maintain and boost economic stability.

Understanding what sticky wages and prices are:

In economics, sticky simply means that something is slow to change. For example, when wages are sticky, employers are often unable or unwilling to adjust wages immediately, even in response to changing market conditions. Similarly, sticky prices mean that businesses are slow to adjust prices up or down based off supply and demand.

Keynesian economists argue that stickiness in general is what prevents the market from returning or finding an equilibrium, or in more technical terms: ‘a major impediment to reaching market equilibrium,’ often resulting in prolonged unemployment or inflation. So, if demand for goods or labour drops suddenly, wages and prices might not fall quickly enough to help the economy recover.

Reasons for wages and prices to be sticky:

1. Long term contracts: Many workers have long-term contracts (especially prevalent in sectors such as manufacturing and government) that persist through economic downturns or recessions, making it difficult for companies to lower wages immediately. 
2. Menu Costs: Adjusting prices and wages often incurs ‘menu costs’—expenses associated with implementing changes. If these costs outweigh the benefits, firms may delay adjusting prices.
3. Social Expectations: Workers will never be happy to have wage cuts, so, they are likely to resist them. Employers may worry that wage cuts will lower workers’ morale and motivation, potentially reducing productivity and output quality.
4. Efficiency Wages: The concept of efficiency wages is that during economic downturn or a recession, some companies might pay above average wages to motivate workers and therefore reduce turnover. During an economic downturn, they might be reluctant to lower wages so to not decrease worker productivity or affect loyalties. As a result, these employers are deciding that they value the benefits of keeping workers productive and loyal outweigh the savings from cutting wages.

The Keynesian AS-AD Model

Explaining Price Stickiness Using This Model:

Low Output and Sticky Prices: 
In the Keynesian view, when the economy is operating below full employment level of output (at output level Y1, for instance), prices tend to be sticky. This is represented by the flatter part of the AS curve, which implies that as demand shifts, there is little to no inflationary pressure and so price level stay relatively the same Instead of adjusting prices down to stimulate demand, firms may keep prices constant due to menu costs, contractual obligations, efficiency wages or social expectations and morale.
Implications of Price Stickiness:
Keynesians argue that prices, like wages, are ‘sticky’ downward, meaning firms may hesitate to reduce prices, as it can signal a perceived drop in quality. This price rigidity can amplify economic downturns.
The model suggests that, in a recession or below full employment scenario, sticky prices prevent prices from dropping enough to boost demand and return the economy to full employment on their own.
The Keynesian model therefore supports policy interventions, such as fiscal stimulus, to shift the AD curve to the right. This is necessary because prices don’t fall naturally to correct the gap, a core idea behind Keynes’s advocacy for active government intervention during economic downturns
 
Mathematical Representation of Sticky Wages:

Mathematical Representation of Price Rigidity:

The Role of Wage Rigidity in Structural Unemployment:

Sticky wages significantly contribute to structural unemployment because they prevent the labour market from adjusting rapidly to shifts in demand across various industries. During economic downturns, the inability to reduce wages quickly can ‘trap labour’ in declining industries rather than allowing it to shift towards more productive sectors, an example of this was seen in the 1950’s as there began to be mass unemployment in areas such as Scotland, Ireland and the North of England as there was overspecialisation in the heavy industry sector, thus, as the economy developed and heavy industry became a declining sector, labour became trapped and there has been significant rates of prolonged unemployment since then. This rigidity imposes an adjustment burden on the economy and as a result, prolongs periods of ‘higher-than-natural’ unemployment (which economics consider to be around 4.5%). To continue the example of heavy industry, wage rigidity may exacerbate the decline by discouraging firms from hiring or retaining workers at existing pay levels. This underscores the ‘flexibility in labour markets,’ as it enables economies to adapt to evolving demands and mitigate long term unemployment.

The Psychological Impact of Nominal Wage Stickiness on Consumer Behaviour:

Wage stickiness does not merely provide direct economic consequences, but nominal wage stickiness also has a profound psychological effect on consumers and it influences their spending patterns and confidence. Behavioural economics highlights that workers perceive wage cuts as signals of reduced firm stability or periods of economic downturn, this in turn negatively impacts consumption in the economy (also therefore shifting the aggregate demand curve inwards). This concept aligns with Keynes’ ‘animal spirits’ concept, where economic agents’ sentiments drive their actions, potentially amplifying recessions (a recession is two consecutive quarters of negative economic growth). When wages are sticky downward, employees can be led to interpret even minor wage holds as an indication of future financial instability, giving them a more negative outlook on future growth, therefore prompting a decrease in spending. 

This can be supported by a study conducted by M. Shapiro on ‘Labour Market Shocks and their Effects on Consumer Spending.’ In this study, Shapiro analyses data from household surveys conducted during the 2008 global financial crisis in order to understand how ‘wage cuts and job insecurity affected consumer spending behaviour.’ The statistics point to the fact that households experiencing wage cuts or fearing future income losses significantly cut spending across most sectors, a more statistical breakdown shows: 

• Discretionary spending decreased by 10-15%
• Precautionary saving increased by 5-8% (MPS increases)
• Spending on durable goods dropped by 20%
• Overall consumption: A reduction of 3% in total consumer spending across the economy

Shapiro’s findings clearly align with Keynes’ theory of ‘animal spirits,’ where psychological factors influence economic behaviour, causing a self sustaining and reinforcing cycle of decreased demand and deeper recessions

How can Sticky Wages and Prices be combatted:

As discovered already, Keynesian Economists believe that the most effective way to combat the concept of stickiness in the economy is through government intervention. Two examples of what the government are able to do are:

1. Fiscal Policy: When the government spends more, it boosts demand. This increase can raise output without needing wages and prices to adjust immediately. 
2. Monetary Policy: Lowering interest rates encourages borrowing and spending, helping to increase demand and fill the output gap that sticky prices and wages create.

• Fiscal Policy impact: As the government injects money into the economy, aggregate demand increases, therefore AD curve shifts from AD1 to AD2. This increase in demand enables firms to raise output and employ more workers, reducing unemployment rates.
• As government spending increases, it initiates the ‘multiplier effect.’ Each pound spent by the government stimulates additional spending by businesses and households, further shifting the aggregate demand curve to the right. This multiplier effect reflects an outward shift in the aggregate demand curve, boosting economic output and pushing the economy closer to the full employment level of output.

Conclusion:

The recent COVID-19 pandemic highlighted the impact of wage and price stickiness, as many firms struggled too reduce wages despite sharp drops in demand, leading to sustained high unemployment. Keynesian economics offers the framework to understand these rigidities and supports the use of government intervention to mitigate their effects.

Sticky wages and prices contribute to economic rigidity, creating gaps in output that may hinder or affect growth. Government intervention, through fiscal and monetary policies, justifies moving the economy towards the full employment level of output (Yfe) ensuring stability and long term prosperity.