Behavioural macroeconomics and wage and price setting: Developing some early insights of John Maynard Keynes and Joan Robinson

Author name: 
McDonald IM

This paper argues that the theory of wage and price setting in macroeconomics should be broadened to include insights from behavioural economics, in particular prospect theory and loss aversion. The paper shows how broader microeconomic foundations can explain the main features of a realistic Phillips curve, which are the concurrence of a steep SRPC at low unemployment, a flat SRPC at high unemployment and speed-limit effects. The resulting macroeconomic model has the benefits of consistency with important properties of natural rate models, especially a crucial role for inflation expectations and, in determining the economy’s macroeconomic potential, for supply factors, plus the benefit of consistency with the standard IS/LM model. The paper also shows that the behavioural aspects of these broader microeconomic foundations were alluded to by Keynes and Robinson in 1936 when macroeconomics was created.

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