The Essential Role of Conventional Beliefs in Economics: Keynesian Unemployment Despite Price Flexibility

This article investigates whether an economy with perfectly flexible prices and wages can experience persistent unemployment, challenging classical and neoclassical views that markets clear efficiently through price adjustments. Adopting a strictly neoclassical framework, but differing from other contributions, the article explores how conventional beliefs shape macroeconomic outcomes. It demonstrates that a recessionary shock can lead to prolonged unemployment when agents adhere to a Keynesian Conventional Belief (KCB), in contrast to the self-correcting outcomes associated with the Walrasian Conventional Belief (WCB). The article concludes that if agents operating in a neoclassical economy hold Keynesian beliefs, the economy's response to shocks will be influenced by these beliefs, resulting in Keynesian outcomes. This analysis underscores the potential of policies targeting nominal stability to stabilize expectations and support full employment while cautioning against excessive reliance on fiscal and monetary interventions in structurally weak economies. Aligning with Keynes’s original policy vision, the article advocates combining “counter-cyclical” macroeconomic policies with “anti-cyclical” public-sector actions to enhance the economy’s productivity and growth potential.