Furthermore, the neoclassical model posits that unemployment can be reduced by a fall in real wages. That said, we want the rate of growth or real wages to be negative. Taking the log-derivative on both sides of equation (4.2), one gets
∆ lnpL
p = − ¯α ¯β.∆ ln pK
p (4.3)
In order to achieve ∆ lnwp < 0, the right-hand term must be negative too. This means that the real price of capital must increase. Intuitively, when the real price of capital increases beyond a certain level, the overall price level increases as well and, for any given nominal wage, the real wage will decrease, reducing unemployment.
We have shown that the labor, capital and output markets are interconnected not just in terms of quantities as in the Cobb-Douglas production function, but also by their prices. We have derived expressions (4.2) and (4.3) relating the relative price of labor to the relative price of capital. Those expressions show that to reduce unemployment, real wages must fall; to reduce real wages the real price of capital must increase. Herein lies the problem: in the 1930s the real price of capital did not rise. In the Great Depression, just like in any recession, the price of capital is more likely to fall than it is to rise. This is true no matter what meaning we give to the notion of “capital.” For instance, if by “price of capital” we mean the price of machinery, then the price of capital is likely to fall as machinery producers liquidate their inventories. Just as well, if by “price of capital” we mean the price of borrowing funds, i.e. the interest rate, the interest rate is usually and was indeed cut (mostly) during the Depression. Finally, if by “price of capital” we mean the price of financial assets, those are likely to fall in a recession too. That said, it appears that no matter how you define the price of capital, a downturn in economic activity is more likely to come with a decrease in the price of capital. As a result, the aggregate price level in a downturn will consist of two components—the price of labor and the price of capital—which are going down, so that real wages are increasing. The labor market requires a fall in real wages to clear, but the deflation characteristic of a downturn means that real wages will rise.
4.2
The Keynesian model
The two stacked graphs to the right of Figure 4.1 can be used to tell a Keynesian narra- tive. The top right graph represents the 45-degree diagram and the bottom right diagram represents the IS-LM model.12,13
12Keynes (1936) never used diagrams and yet much of his writing lends itself to modern representations
using graphs. The IS-LM model of Hicks (1937) presents such interpretation.
The 45-degree line diagram is used to present the aggregate demand function Z which consists of all (planned) expenditures adding up to GDP. When those planned expenditures are realized, they amount to a certain level of economic activity Y . This level of economic activity can then be compared to the level of potential output which, at any given point in time, represents the level of economic activity resulting from the full employment of all resources. The gap between realized expenditures and potential output is called the output gap and, by definition, it is commensurate with the extent of unused resources. The graph is drawn to represent two levels of possible expenditures. The firstZ0 represents the point of
effective demand. That is, the level of expenditures compatible with an output gap of zero and a full employment of resources. The second Z1 represents a position of unused resources,
positive output gap, and therefore some degree of unemployment. It is important to note that, contrary to the neoclassical model where unemployment is the consequence of voluntary unemployment—the truculence of labor demanding too high wages—the Keynesian model attributes unemployment to a lack of aggregate spending. The amount of aggregate spending is outside of the control of individuals, who then turn out to be involuntarily unemployed.
The bottom graph represents the IS-LM model (Hicks 1937). The graph represents the investment-saving (IS) schedule which is used to depict all possible equilibrium positions on the goods market, and is used to assess the effects of fiscal policy. The liquidity-money (LM) schedule represents all possible equilibrium positions in the market for loanable funds, and the curve is used to assess the effects of monetary policy. The IS-LM graph is drawn to match the 45-degree-line diagram, using their common elements such as the bottom axis Y , the level of potential output and the extent of the output gap.
Policy implications Because the Keynesian model explicitly accounts for a positive out- put gap, it is no surprise that economic policy is a integral part of the model. We need not explain the precise reasons as to why the economy can or did deviate from its potential, full-employment level of output. The fact of the matter is that, during the Great Depression, the economy was substantially under-performing, as evidenced by widespread unemployment of 25-30 percent of the labor force. However, we do go into the policy implications of such a low equilibrium point as represented by Z1.
The 45-degree line diagram indicates that this equilibrium point results in unemployment and can be remedied by an increase in spending. The IS-LM graph tells the same story but is more detailed: the required increase in actual spending can be triggered by shifts to the right of the IS curve, the LM curve, or both jointly. That is to say, unemployment and the output gap can be shrunk by increasing spending through, respectively, fiscal and/or monetary policies. Here, the typical fiscal policy measure is an increase in government spending G