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

From the global perspective, if our model loses asymptotic stability for higher adjustment
speeds, in the present framework specifically of prices and the inflationary climate, purely
explosive behavior is the generally observed outcome, as is easily checked by means of
numerical simulations. The considered so far only intrinsically nonlinear model type
therefore cannot be considered as being complete in such circumstances, since some
mechanism is then required to bound the fluctuations to economically viable regions.
Downward money wage rigidity is the mechanism we have often used for this purpose
and which we will use here again, see the numerical investigations in Asada, Chiarella,
Flaschel and Hung (2004). Extended in this way, by simply excluding deflation (to
some extent) for m occurring, we obtain and study a baseline model of the DAS-DAD
variety with a rich set of stability implications and with various types of business cycle
fluctuations that it can generate endogenously or by adding stochastic shocks to the
considered dynamics.

The dynamic outcomes of this baseline disequilibrium AS-AD or DAS-DAD model can
be usefully contrasted with those of the currently fashionable New Keynesian alternative
(the Neoclassical Synthesis, stage II) that in our view is more limited in scope, at least
as far as the treatment of interacting Keynesian feedback mechanisms and the thereby
implied dynamic possibilities are concerned. This comparison reveals in particular that
one does not always end up with the typical (in our view strange) dynamics of rational
expectation models, due to certain types of forward looking behavior, if such behavior is
coupled with plausible backward looking behavior for the medium-run evolution of the
economy. This basic insight is now also stressed in New Keynesian approaches due to
the complete empirical failure of their New Phillips curve.

Our dual Phillips curves approach to the wage-price spiral indeed performs quite well,
when estimated empirically, as we shall show in this paper,³ in particular does not
give rise to the situation observed for the New (Keynesian) Phillips curve, found to be
completely at odds with the facts in the literature ⁴ . In our approach standard Keynesian
feedback mechanisms are coupled with a wage-price spiral having a considerable degree
of inertia, with the result that these feedback mechanisms work - as is known from
partial analysis - in their interaction with the added wage and price level dynamics.

The present paper therefore intends to provide a proper baseline model of the Keynesian
DAS-DAD variety, not plagued by the theoretical anomalies of the traditional AS-AD
model and the empirical anomalies of the New Keynesian approach. It does so on the
basis of the fully specified DAS-AD growth dynamics of Asada, Chen, Chiarella and
Flaschel (2004), by transforming this dynamics into a reduced DAS-DAD form that can
be estimated empirically. It discusses the feedback structure of this reduced form and
its stability implications, first on a general level and then on the level of the sign restric-
tions obtained from empirical estimates of the five laws of motion of the dynamics. These
estimates also allow us to show asymptotic stability for the estimated parameter sizes
and to determine stability boundaries (with respect to price flexibility and the speed of

³See also Flaschel and Krolzig (2004), Flaschel, Kauermann and Semmler (2004) and Chen and
Flaschel (2004).

⁴In this connection, see for example Mankiw (2001) and with much more emphasis Eller and Gordon
(2003), whereas Gali, Gertler and Lopez-Salido (2003) argue in favor of a hybrid form of the New
Phillips Curve.

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