The Inflexible Price and Wage Theory of the Business Cycle

The inflexible price and wage theory of the business cycle says that capitalists and businessmen are reluctant to change prices and therefore, in the face of continuously rising spending, business owners step up production since there will be more demand for goods with a greater volume of spending if prices have not risen to offset the spending. This constitutes the essence of the expansion phase of the business cycle. Eventually, businessmen give in and raise prices because, as advocates of this theory state, firms run out of excess capacity with which to increase production. Hence, prices rise to catch up with the increased spending, production is reduced, and the contraction phase of the business cycle sets in.

The above description is one way Keynesians use “sticky price and wage theory” to explain the business cycle. Another version of the theory says that spending increases during the expansion but decreases during the contraction. The expansion phase in this version looks like the expansion phase discussed in the first version of the theory. As spending increases during the expansion, prices and wages do not rise quickly enough and thus employment and output expand in response. If prices and wages increased sufficiently in the face of the increased spending, according to Keynesians, no increased output or employment would result.

The contraction phase is a little different than in the first version of the theory. Here, as spending contracts during the recession or depression, prices and wages do not fall quickly enough to offset the decreased spending. If they did fall quickly enough, the same goods and labor could be purchased with the decreased money and spending. Therefore, output and employment would not decline and the contraction could be averted. In this scenario, inflexible price and wage theory is supposed to explain why output fluctuates more during the cycle than prices. It is also supposed to explain why recessions and depressions can be so deep and last so long.

--Brian P. Simpson, Remedies and Alternative Theories, vol. 2 of Money, Banking, and the Business Cycle (New York: Palgrave Macmillan, 2014), 46.