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.
2.9.1 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 nomi-nal 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.
66 Modern macroeconomics
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 theo-retical 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 circum-stances extreme flexibility of the nominal wage in a monetary economy would in all probability make the situation worse.
Figure 2.6 Keynes and involuntary unemployment
68 Modern macroeconomics 2.9.2 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 govern-ment 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 invest-ment 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).