I have an amateur interest in economics so forgive me if I display my ignorance. From my understanding, both in the Keynesian and monetarist theory of recessions, the recession occurs because aggregate demand decreases and wages are sticky/rigid. Measures like quantitative easing or government stimulus spending try to raise the level of aggregate spending relative to these "sticky" wages. However, what is to prevent a government taking a much more direct method and just mandating a wage cut throughout the whole economy? Wouldn't this be far more effective and far less prone to abuse than fiscal or monetary stimulus?

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    $\begingroup$ Because people tend to not hold the government popular if their salary is decreased by that government's decree. In the best case scenario, you lose an election. $\endgroup$
    – DVK
    May 20 '18 at 11:45

I will only attempt to give a partial answer, since the full answer is very large. You could possibly create new questions that are narrower to follow up. (My feeling is that this website works best on narrower questions.)

  1. One possibility is that New Keynesian theory is just plain wrong. As a disclaimer, that is my view. However, that is a controversial view.
  2. The next issue are practical problems that standard New Keynesian models ignore.

I am not going to discuss (1) in great length. I think the standard critique of sticky prices (which goes back to Keynes) is that you are cutting nominal demand at the same time. The economy will not return to full employment, partly for reasons I cover in (2).

The problems with trying to cut wages and prices are as follows.

  • Legal. Does the government have the authority to do so?
  • Practical. How do we know whether a firm has complied, without having a ministry in charge of price administration? It’s not as if workers will voluntarily run to the government to say that their wages were not cut. We cannot put in place such a ministry during a recession, which typically lasts months.
  • Ignores the effect of debt. Most people and firms have mortgages and other fixed obligations. Broad-based income cuts would result in a mass default event, which will cause a recession to turn into a full-fledged financial crisis.
  • The government has just seized control of price setting (which was historically done in the 1970s to control inflation). How does it set prices in order to achieve its objective? How does the government exit?

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