Keynesian Dynamics and the Wage-Price Spiral:Estimating a Baseline Disequilibrium Approach



1 Introduction

In this paper we reformulate and extend the standard AS-AD growth dynamics of the
Neoclassical Synthesis (Stage I) with its traditional microfoundations, as it is for example
treated in detail in Sargent (1987, Ch.5). Our reformulation, based on our earlier pre-
sentation and analysis of a DAS-AD alternative to the neoclassical AS-AD framework,
see Asada, Chen, Chiarella, Flaschel (2004), now replaces their LM curve with a Taylor
interest rate policy rule, as in the New Keynesian approaches. The model, as well as
its predecessor, exhibits sticky wages as well as sticky prices, underutilized labor as well
as capital stock, myopic perfect foresight of current wage and price inflation rates and
adaptively formed medium run expectations concerning the inflation climate in which
the economy is operating. Moreover we now employ a dynamic IS-equation in the place
of the static one of Asada, Chen, Chiarella, Flaschel (2004) and will also make use of a
dynamic form of Okun’s law to a certain extent. The resulting nonlinear 5D model of
labor and goods market disequilibrium dynamics (with a Taylor type treatment of the
financial part of the economy) avoids the striking anomalies of the conventional AS-AD
model of the Neoclassical synthesis under myopic perfect foresight, stage I.
1 Instead it
exhibits Keynesian feedback dynamics proper with in particular asymptotic stability of
its unique interior steady state solution for low adjustment speeds of wages, prices, and
expectations among others. The loss of stability occurs cyclically, by way of Hopf bifur-
cations, when some of these adjustment speeds are made sufficiently large, even leading
eventually to purely explosive dynamics sooner or later. This latter fact - if it occurs
- implies the need to look for appropriate extrinsic nonlinearities that can bound the
dynamics in an economically meaningful domain, such as downward rigidity of wages
and prices and the like, if the economy departs too much from its steady state position.

Locally we thus obtain and can prove the existence of in general damped, persistent or
explosive fluctuations in the real and the nominal part of the dynamics, in the rates of
capacity utilization of both labor and capital, and of wage and price inflation rates which
here induce interest rate adjustments by the monetary authority that attempt to stabilize
the observed output and price level fluctuations. Our modification and extension of
traditional AS-AD growth dynamics, as investigated from the orthodox point of view in
Sargent (1987), thus provides us with a Keynesian theory of the business cycle, including
a modern approach to monetary policy. This is even true in the case of myopic perfect
foresight, where the structure of the traditional approach radically dichotomizes into
independent classical supply-side and real dynamics - that cannot be influenced by
monetary policy - and a subsequently determined inflation dynamics, that are purely
explosive if the price level is taken as a predetermined variable, a situation that forced
convergence by an inconsistent application of the jump-variable technique
2 in Sargent
(1987,ch.5), see again Asada, Chen, Chiarella and Flaschel (2004) for details. In our
new type of Keynesian labor and goods market dynamics we however can treat myopic
perfect foresight of both firms and wage earners without the need for the methodology
of the rational expectations approach to unstable saddlepoint dynamics.

1 These anomalies include in particular saddle point dynamics that imply instability unless some
poorly motivated jumps - and indeed flawed - are imposed on certain variables, here on both the price
and the wage level, see Asada, Chen, Chiarella and Flaschel (2004) for details.

2 since the nominal wage is transformed into a non-predetermined variable there.



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