Keynes’s Analysis of the Labour Market
We have already seen (section 2.3) that full employment is guaranteed in the
classical model providing that competition prevails in the labour market, and
prices and wages are perfectly flexible (see Figures 2.2 and 2.4). In sharp
contrast, Keynes did not accept that the labour market worked in a way that
would always ensure market clearing. Involuntary unemployment is likely to
be a feature of the labour market if money wages are rigid. But Keynes went
further than this and argued that flexibility of nominal wages would be
unlikely to generate powerful enough forces which could lead the economy
back to full employment. Let us examine each of these cases.
Rigidity of nominal wages
In the General Theory, to begin with, Keynes assumes that the money wage is
‘constant’ in order to ‘facilitate the exposition’ while noting that the ‘essential
character of the argument is precisely the same whether or not money-wages
are liable to change’ (Keynes, 1936, p. 27). We can see the impact of a
negative demand shock on real output and employment in the case of nominal
wage rigidity by referring to Figure 2.6. Suppose an economy which is
initially in equilibrium at full employment (Le and YF) experiences a fall in
aggregate demand illustrated by a shift of the AD curve from AD0 to AD1. If
prices are flexible but nominal wages are rigid, the economy moves from e0
to e1 in panel (b). With nominal wage rigidity the aggregate supply curve
becomes W0AS. With a fall in the price level to P1, and nominal wages
remaining at W0, the real wage increases to W0/P1 in panel (a). At this real
wage the supply of labour (Ld) exceeds the demand for labour (Lc) and
involuntary unemployment of cd emerges.
According to Keynes (1936, p. 15) workers are involuntarily unemployed
if ‘in the event of a small rise in the price of wage-goods relatively to the
money-wage, both the aggregate supply of labour willing to work for the
current money-wage and the aggregate demand for it at that wage would be
greater than the existing volume of employment’. This makes sense when we
remember that the labour supply curve indicates the maximum amount of
labour supplied at each real wage. Since Le – Lc part of the involuntarily
unemployed workers are prepared to work for the equilibrium real wage W0/
P0 a fall in the real wage from W0/P1 to W0 /P0 is acceptable to them since
they would have been prepared to work for a lower real wage, as indicated by
the supply curve for labour between b and e. A fall in the real wage will also
induce profit-maximizing firms to demand more labour.
But how can the real wage be reduced? There are basically two ways.
Either money wages must fall relative to the price level, or the price level
must rise relative to the nominal wage. Keynes favoured the latter, and
advocated expansions of aggregate demand in order to exert upward pressure
on the price level. In terms of Figure 2.6, panel (b), policies are required
which will shift AD from AD1 to AD0. The rise in the price level from P1 to P0
reduces the real wage back to its equilibrium level of W0/P0 and involuntary
unemployment is eliminated. Keynes rejected the alternative policy of wage
cutting as a method of stimulating employment on both practical and theoretical
grounds. The practical reason was that in a democracy characterized
by decentralized wage bargaining wage reductions are only likely to occur
after ‘wasteful and disastrous struggles’, producing an end result which is not
justifiable on any criterion of social justice or economic expediency (see
Chapters 3 and 19 of the General Theory). Keynes also argued that workers
will not resist real wage reductions brought about by an increase in the
general price level, since this will leave relative real wages unchanged and
this is a major concern of workers. We should note that this does not imply
money illusion on the part of workers. The resistance to money wage cuts and
acceptance of reductions in the real wage via a general rise in the cost of
living has the advantage of preserving the existing structure of relativities
(see Trevithick, 1975; Keynes, 1936, p. 14). In any case, since labour can
only bargain over money wages and the price level is outside their control,
there is no way in which labour as a whole can reduce its real wage by
revising money wage bargains with entrepreneurs (Keynes, 1936, p. 13). But
Keynes went further in his objections to nominal wage cutting than these
practical issues. He rejected wage and price flexibility as a reliable method of
restoring equilibrium on theoretical grounds also. Indeed, in many circumstances
extreme flexibility of the nominal wage in a monetary economy
would in all probability make the situation worse.
Flexibility of nominal wages
Many orthodox Keynesians place money wage rigidity at the centre of Keynes’s
explanation of involuntary unemployment in The General Theory (see
Modigliani, 1944, 2003; Snowdon and Vane, 1999b; Snowdon, 2004a). Keynes
demonstrated in the General Theory that the way in which nominal wage cuts
would cure unemployment would operate primarily through their impact on
the interest rate. If wage cuts allowed further reductions of the price level,
this would increase the real value of the money supply, lower interest rates
and stimulate investment spending. In terms of Figure 2.6, panel (b), the
falling money wage shifts the aggregate supply curve from W0AS to W1AS
(where W1 < W0). The economy would return to full employment at e2. The
price mechanism has allowed aggregate demand to increase without government
intervention in the form of an aggregate demand stimulus. However, as
we will see more clearly in Chapter 3, section 3.4.2, Keynes introduced two
reasons why this ‘Keynes effect’ might fail. The existence of a liquidity trap
which prevents the interest rate from falling or an interest-inelastic investment
schedule could prevent falling prices from stimulating aggregate demand
via changes in the interest rate. In terms of Figure 2.6, panel (b), these
possible limitations of deflation as a route to recovery would show up as an
AD curve which becomes vertical below e1; that is, the economy is prevented
from moving from e1 to e2.
For Keynes the policy of allowing money wages to fall for a given money
supply could, in theory, produce the same effects as a policy of expanding the
money supply with a given nominal wage. But since this was the case,
monetary policy was subject to the same limitations as wage cutting as a
method of securing full employment. However, a severe deflation of prices
would also be likely to have adverse repercussions on business expectations,
which could lead to further declines of aggregate demand (see Keynes, 1936,
p. 269). The impact of severe deflation on the propensity to consume via
distributional effects was also likely to be ‘adverse’ (Keynes, 1936, p. 262).
In summing up these issues, Keynes took a pragmatic stance.
Having regard to human nature and our institutions, it can only be a foolish person
who would prefer a flexible wage policy to a flexible money policy … to suppose
that a flexible wage policy is a right and proper adjunct of a system which on the
whole is one of laissez-faire, is the opposite of the truth. (Keynes, 1936, pp. 268–
9; see also Modigliani, 2003)
Because of these various limitations of the price mechanism, Keynes was
convinced that the authorities would need to take positive action in order to
eliminate involuntary unemployment. Unless they did so the system could
find itself caught in a situation of underemployment equilibrium, by which he
meant the tendency of market economies to remain in a chronic condition of
subnormal activity for a considerable period ‘without any marked tendency
either towards recovery or towards complete collapse’ (Keynes, 1936, p. 249).
We have already seen (section 2.3) that full employment is guaranteed in the
classical model providing that competition prevails in the labour market, and
prices and wages are perfectly flexible (see Figures 2.2 and 2.4). In sharp
contrast, Keynes did not accept that the labour market worked in a way that
would always ensure market clearing. Involuntary unemployment is likely to
be a feature of the labour market if money wages are rigid. But Keynes went
further than this and argued that flexibility of nominal wages would be
unlikely to generate powerful enough forces which could lead the economy
back to full employment. Let us examine each of these cases.
Rigidity of nominal wages
In the General Theory, to begin with, Keynes assumes that the money wage is
‘constant’ in order to ‘facilitate the exposition’ while noting that the ‘essential
character of the argument is precisely the same whether or not money-wages
are liable to change’ (Keynes, 1936, p. 27). We can see the impact of a
negative demand shock on real output and employment in the case of nominal
wage rigidity by referring to Figure 2.6. Suppose an economy which is
initially in equilibrium at full employment (Le and YF) experiences a fall in
aggregate demand illustrated by a shift of the AD curve from AD0 to AD1. If
prices are flexible but nominal wages are rigid, the economy moves from e0
to e1 in panel (b). With nominal wage rigidity the aggregate supply curve
becomes W0AS. With a fall in the price level to P1, and nominal wages
remaining at W0, the real wage increases to W0/P1 in panel (a). At this real
wage the supply of labour (Ld) exceeds the demand for labour (Lc) and
involuntary unemployment of cd emerges.
According to Keynes (1936, p. 15) workers are involuntarily unemployed
if ‘in the event of a small rise in the price of wage-goods relatively to the
money-wage, both the aggregate supply of labour willing to work for the
current money-wage and the aggregate demand for it at that wage would be
greater than the existing volume of employment’. This makes sense when we
remember that the labour supply curve indicates the maximum amount of
labour supplied at each real wage. Since Le – Lc part of the involuntarily
unemployed workers are prepared to work for the equilibrium real wage W0/
P0 a fall in the real wage from W0/P1 to W0 /P0 is acceptable to them since
they would have been prepared to work for a lower real wage, as indicated by
the supply curve for labour between b and e. A fall in the real wage will also
induce profit-maximizing firms to demand more labour.
But how can the real wage be reduced? There are basically two ways.
Either money wages must fall relative to the price level, or the price level
must rise relative to the nominal wage. Keynes favoured the latter, and
advocated expansions of aggregate demand in order to exert upward pressure
on the price level. In terms of Figure 2.6, panel (b), policies are required
which will shift AD from AD1 to AD0. The rise in the price level from P1 to P0
reduces the real wage back to its equilibrium level of W0/P0 and involuntary
unemployment is eliminated. Keynes rejected the alternative policy of wage
cutting as a method of stimulating employment on both practical and theoretical
grounds. The practical reason was that in a democracy characterized
by decentralized wage bargaining wage reductions are only likely to occur
after ‘wasteful and disastrous struggles’, producing an end result which is not
justifiable on any criterion of social justice or economic expediency (see
Chapters 3 and 19 of the General Theory). Keynes also argued that workers
will not resist real wage reductions brought about by an increase in the
general price level, since this will leave relative real wages unchanged and
this is a major concern of workers. We should note that this does not imply
money illusion on the part of workers. The resistance to money wage cuts and
acceptance of reductions in the real wage via a general rise in the cost of
living has the advantage of preserving the existing structure of relativities
(see Trevithick, 1975; Keynes, 1936, p. 14). In any case, since labour can
only bargain over money wages and the price level is outside their control,
there is no way in which labour as a whole can reduce its real wage by
revising money wage bargains with entrepreneurs (Keynes, 1936, p. 13). But
Keynes went further in his objections to nominal wage cutting than these
practical issues. He rejected wage and price flexibility as a reliable method of
restoring equilibrium on theoretical grounds also. Indeed, in many circumstances
extreme flexibility of the nominal wage in a monetary economy
would in all probability make the situation worse.
Flexibility of nominal wages
Many orthodox Keynesians place money wage rigidity at the centre of Keynes’s
explanation of involuntary unemployment in The General Theory (see
Modigliani, 1944, 2003; Snowdon and Vane, 1999b; Snowdon, 2004a). Keynes
demonstrated in the General Theory that the way in which nominal wage cuts
would cure unemployment would operate primarily through their impact on
the interest rate. If wage cuts allowed further reductions of the price level,
this would increase the real value of the money supply, lower interest rates
and stimulate investment spending. In terms of Figure 2.6, panel (b), the
falling money wage shifts the aggregate supply curve from W0AS to W1AS
(where W1 < W0). The economy would return to full employment at e2. The
price mechanism has allowed aggregate demand to increase without government
intervention in the form of an aggregate demand stimulus. However, as
we will see more clearly in Chapter 3, section 3.4.2, Keynes introduced two
reasons why this ‘Keynes effect’ might fail. The existence of a liquidity trap
which prevents the interest rate from falling or an interest-inelastic investment
schedule could prevent falling prices from stimulating aggregate demand
via changes in the interest rate. In terms of Figure 2.6, panel (b), these
possible limitations of deflation as a route to recovery would show up as an
AD curve which becomes vertical below e1; that is, the economy is prevented
from moving from e1 to e2.
For Keynes the policy of allowing money wages to fall for a given money
supply could, in theory, produce the same effects as a policy of expanding the
money supply with a given nominal wage. But since this was the case,
monetary policy was subject to the same limitations as wage cutting as a
method of securing full employment. However, a severe deflation of prices
would also be likely to have adverse repercussions on business expectations,
which could lead to further declines of aggregate demand (see Keynes, 1936,
p. 269). The impact of severe deflation on the propensity to consume via
distributional effects was also likely to be ‘adverse’ (Keynes, 1936, p. 262).
In summing up these issues, Keynes took a pragmatic stance.
Having regard to human nature and our institutions, it can only be a foolish person
who would prefer a flexible wage policy to a flexible money policy … to suppose
that a flexible wage policy is a right and proper adjunct of a system which on the
whole is one of laissez-faire, is the opposite of the truth. (Keynes, 1936, pp. 268–
9; see also Modigliani, 2003)
Because of these various limitations of the price mechanism, Keynes was
convinced that the authorities would need to take positive action in order to
eliminate involuntary unemployment. Unless they did so the system could
find itself caught in a situation of underemployment equilibrium, by which he
meant the tendency of market economies to remain in a chronic condition of
subnormal activity for a considerable period ‘without any marked tendency
either towards recovery or towards complete collapse’ (Keynes, 1936, p. 249).
Where is diagram?
ReplyDelete