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11 Unemployment
and
Inflation
Chapter Outline
In Chapter 10, we discussed issues relating to labour market measurement. In this Chapter we will focus on
theoretical concepts that underpin the measurement of economic activity in the labour market and the broader
economy.
The Chapter has five main aims:

To explain why mass unemployment arises and how it can be resolved.

To develop the concept of full employment.

To consider the relationship between unemployment and inflation – the so-called Phillips
Curve.

To develop a buffer stock framework for macroeconomic management (full employment and
price stability) and compare and contrast the use of unemployment and employment as buffer
stocks in this context.

To more fully explore the concept of a Job Guarantee (employment buffer stock) approach to
macroeconomic management.
[NOTE THE INTRODUCTION WILL BE EXTENDED ONCE THE BODY OF THE CHAPTER IS
COMPLETED]
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11.1
Categories of Unemployment
Economists have long used taxonomies to organise their thoughts about unemployment. Two often used
categorisations focus on the distinction between frictional, structural, cyclical (demand-deficient), and seasonal
categories, on the one hand; and, the distinction between voluntary and involuntary unemployment on the other
hand.
These taxonomies can cut across each other and neither one is better than the other. The categorisation system
depends on the purpose of the analysis. In general, economists have married these categorisation frameworks
into broader theoretical discussions which seek to explain why unemployment arises, whether it is a problem or
not, and what can be done about it via policy interventions should we consider it to be a problem.
The most popular typology used to describe unemployment distinguishes between frictional, structural, cyclical
(demand-deficient), and seasonal unemployment.
Frictional unemployment – it is recognised that the labour market is in a constant state of flux. Jobs are
continually being created and destroyed, which means that workers who have been laid-off or quit are moving
between jobs while firms are seeking workers for new jobs created or to fill existing jobs where the previous
incumbent has left.
Further, new entrants into the labour force seek work while retirees leave jobs. Frictional unemployment arises
because the matching of these demand and supply flows is not instantaneous. It takes time for workers and
employers to gather relevant information and move between labour force states. Frictional unemployment is
considered to be a short-term phenomenon and part of normal functioning of the labour market. While it is
debatable, this category would comprise around 1 to 2 per cent of the labour force.
Seasonal unemployment – arises when certain occupational skill groups and industry sectors experience
fluctuations over the course of the year, which is of a systematic (seasonal) nature. For example, in certain
regions, workers who are engaged in harvesting of agricultural crops will experience seasonal unemployment as
they move between crops and localities. This category is considered to be small in magnitude when assessed on
a macroeconomic scale. It is also difficult to distinguish it from frictional unemployment.
Structural unemployment – is said to arise then there are enough jobs available overall to match the total pool of
unemployment but that there are mismatches between the skill demanded and the skills supplied and/or between
the location of the jobs available and the location of the unemployment. This category of unemployment is often
discussed in the context of industrial restructuring (for example, the decline of the manufacturing sector or
deindustrialisation). Changes in the composition of industry create job losses in declining sectors and new job
opportunities in emerging sectors.
Further, given that industry is not spread evenly across regional space, the decline of a major firm in one region
will have significant implications for the local labour market.
Changes in technology are also considered to have structural impacts in the sense that new skills become
relevant while old skills cease to be in demand by firms.
All of these disruptions to the pattern of employment take time to resolve. The relocation and re-training of
workers displaced by structural change is sometimes a lengthy process. It is the changing pattern of required
skills, the changing location of jobs and the extended time taken to resolve the resulting demand and supply
imbalances that distinguishes the concept of structural unemployment from frictional unemployment.
However, there are two important qualifications to the normal conceptualisation of structural unemployment,
which is not often considered in the mainstream textbooks.
First, the concept of a skills shortage is a relative concept, implying some distance from an optimal state, which
begs the question: according to whom. Unsurprisingly, analyses of skills shortages by industry and governments
invariably consider the issue from the perspective of business and profitability, which places the emphasis on
containment of labour costs both in terms of wages and conditions, and hence, whenever possible, externalising
the costs associated with developing the skills firms require in their workers.
Within this context the notion of structural unemployment arising from “skills mismatch” can be understood as
implying an unwillingness of firms to offer jobs (with attached training opportunities) to unemployed workers
that they deem to have undesirable characteristics. When the labour market is tight, the willingness of firms to
indulge in their prejudices is more costly. However, when labour underutilisation is high, firms can easily
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increase their hiring standards (broaden the desired characteristics they demand from workers) and the training
dynamism driven by labour shortages is lost. Then we observe, in a static sense, ‘skill mismatches’ which are
really symptoms of a ‘low pressure’ economy.
Second, the fact that hiring standards and the willingness of firms to offer training slots to correspond with job
offers varies with economic activity means that the concept of structural unemployment is difficult to
distinguish from the next category of unemployment we define, which is related to a lack of aggregate demand
in the economy.
In other words, there is a significant overlapping between these categories, which reduce their capacity to
provide a definitive decomposition of total unemployment.
Cyclical (demand-deficient) unemployment – arises when there is a shortage of jobs overall relative to the
willing supply of labour resources (persons and hours) at the current wage levels. This category is termed
demand-deficient unemployment because it relates to a deficiency in aggregate demand. Unemployment thus
varies over the economic cycle – rising when aggregate spending falls below the level needed to fully employ
the available workforce and falling when aggregate spending moves closer to the level needed to full employ the
available supply of labour.
Cyclical unemployment is also known as mass unemployment and arises because of the macroeconomic system
fails to generate enough jobs to match the preferences of the available workforce. It is also related to the concept
of an output gap, which measures the percentage deviation of real GDP from the potential production levels at
any point in time.
During an economic downturn (which may become a recession), cyclical unemployment will be the dominant
proportion of measured unemployment. When economic activity improves as a result of increased aggregate
demand, cyclical unemployment falls.
In Chapter 10, we saw that the costs of unemployment (associated with output gaps) are enormous, which makes
the elimination of cyclical unemployment a policy imperative. The solution to cyclical unemployment is thus to
increase the growth rate of aggregate demand to close any output gaps.
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11.2
Why Does Mass Unemployment Arise?
In this Section, we consider the concept of cyclical unemployment in more detail, which will then allow us to
understand what the achievement of full employment requires. We seek to develop a conceptual understanding
of why mass unemployment occurs, why it persists and what policy solutions are available to alleviate it.
A Simplified Economy
We start with an incredibly simple economy to fix the essential idea. This economy is populated by two people,
one being government, which issues the currency, and the other, being the private (non-government) sector, that
uses the currency that the government issues.
In addition to being the sole issuer of the currency, the government also demands that all tax obligations to the
state are relinquished in that currency. Government spending is designed to move private activity into the public
sector – that is hire private productive resources and utilise them for public purposes – to fulfill the
government’s socio-economic goals.
As is the case in the real world, the vast majority of government spending and taxation is accomplished by
electronic transfers (via computer systems) between public and private bank accounts.
If the government runs a balanced budget (for example, spends 100 dollars and taxes 100 dollars) then the
private accumulation of fiat currency (saving) is impossible (that is, it is zero) in that period and the private
budget is also balanced.
The other observation is that in order to pay the 100 dollar tax liability, the non-government person has to accept
payment from the government for their services (perhaps in the form of a wage or a sale of a commodity). The
non-government sector does not have dollars until the government sector spends them. That is a defining feature
of a fiat currency system, as was explained in Chapter 3 Governments and Money.
Say the government spends $120 and taxes remain at $100, then the private sector can save a maximum of $20,
which allows it to accumulate financial assets denominated in the currency of issue up to that amount.
In other words, the government has increased its expenses by $20 and is now running a deficit of that amount. It
had no financial constraints in increasing spending by $20 above its tax revenue because it issues the currency
and can credit private bank accounts for sums of its choice. Clearly, the extra volume of spending would only be
possible if it elicited that much extra economic activity from the private sector.
The government deficit of $20 is exactly the private saving of $20. Now if government continued in this vein,
accumulated private savings would equal the cumulative budget deficits.
The government may decide to issue an interest-bearing bond to encourage saving but operationally it does not
have to do this to finance its deficit. The introduction of a bond merely gives the private sector a chance to
diversify their financial wealth (the accumulated flows of its saving). In other words, the private sector can
choose to hold its wealth as cash or bonds and in Chapter 14, which examines monetary policy, we will consider
the factors that influence that choice.
What would happen if the government decided to run a surplus (say spend $80 and tax $100)? Then the private
(non-government) sector would owe the government a net tax payment of $20, given that the private sector’s
income would be $80 and its tax liabilities would be $100.
Where would the private sector get the funds to meet this shortfall? It would either draw down its cash savings
and/or sell a bond back to the government to get the needed funds. Given that it is typically preferable to hold
one’s financial wealth in the form of an asset that generates a return as opposed to non-interest bearing cash,
then the shortfall will be covered by the government buying back some bonds it had previously sold to the
private sector.
Either way accumulated private saving is reduced dollar-for-dollar when there is a government surplus.
The government surplus has two negative effects for the private sector:

The stock of financial assets (money or bonds) held by the private sector, which represents its
wealth, falls; and

Private disposable income also falls in line with the net taxation impost. In this context, there
is less economic activity than before and less employment. The economy has no
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“unemployed” resources, given that the private sector were willing to supply productive
resources up to $120 in the previous period.
You might respond by saying that the government bond purchases provide the private wealth-holder with cash
and so the transaction involves a portfolio shift. In the first instance, that is true. But why would the private
sector need that cash? In this instance, the liquidation of wealth is driven by the shortage of cash in the private
sector arising from the tax liabilities exceeding private income. The cash from the bond sales pays the
Government’s net tax bill and so net financial wealth falls.
The result is exactly the same when expanding this example by allowing for private income generation, a
banking sector and diversifying the non-government sector into a foreign and domestic sector.
The simplified (unrealistic) example just serves to make the accounting clearer and helps us to understand why
mass unemployment arises.
The Possibility of Unemployment
In this Section we are considering unemployment that arises from a shortage of aggregate demand. It is the
introduction of “state money”, which we discussed in Chapter 3, that raises the possibility of unemployment. If
we could conceive of a non-monetary economy, we would quickly realise that there would be no possibility of
unemployment arising.
In Chapter 3, we understood that a government that issues its own currency does not have to raise taxes or issue
a financial asset (bond) in order to spend. So the government in a fiat monetary system is not said to be
“revenue-constrained”.
The idea of a government that is not revenue-constrained is hard to grasp when we are initially confronted with
it. Intuitively this is hard to accept because we are so wedded to the idea that the purposes of taxes is to raise
money so that the government can spend. In our simple economy, it was clear that the private capacity to pay
taxes post-dated the decision by the government to spend. The private sector required the government to spend
dollars into existence before it could honour its tax liabilities.
You will be asking: if taxation is not required to raise revenue, which permits the government to spend, then
what function does it serve?
In Chapter 3, we explored the concept of functional finance, which considered government spending and
taxation to be tools by which the government achieved its goals of full employment and price stability. That is,
fiscal policy should be functional and not seen as an end in itself. In the modern era, we observe governments
espousing aims that are specified purely in terms of financial ratios, which of themselves are not functionally
important.
In the context of functional finance, we learned that government should seek to maintain a reasonable level of
demand at all times. If there is too little spending and, thus, excessive unemployment, the government shall
reduce taxes or increase its own spending. If there is too much spending, the government shall prevent inflation
by reducing its own expenditures or by increasing taxes.
So taxation is what we consider to be one spoke in the macroeconomic steering wheel that the government uses
to regulate economic activity.
In a famous article – The Economic Steering Wheel – written in 1941 by US economist Abba Lerner (who
coined the term functional finance), which was reproduced as Chapter 1 of his 1951 book, we read:
Our economic system is frequently put to shame in being displayed before an imaginary visitor
from a strange planet. It is time to reverse this procedure. Imagine yourself in a Buck Rogers
interplanetary adventure, looking at a highway in a City of Tomorrow. The highway is wide and
straight, and its edges are turned up so that it is almost impossible for a car to run off the road.
What appears to be a runaway car is speeding along the road and veering off to one side. As it
approaches the rising edge of the highway, its front wheels are turned so that it gets back onto the
road and goes off at an angle, making for the other side, where the wheels are turned again. This
happens many times, the car zigzagging but keeping on the highway until it is out of sight. You
are wondering how long it will take for it to crash, when another car appears which behaves in the
same fashion. When it comes near you, it stops with a jerk. A door is opened, and an occupants
asks whether you would like a lift. You look into the car and before you can control yourself you
cry out, “Why, there’s no steering wheel”. Want a ride?
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In other words, macroeconomic policy-making is all about “steering” the spending fluctuations in the economy,
which drive variations in production and employment. Fiscal policy is the steering wheel and should be applied
for functional purposes, which includes to eliminate cyclical unemployment. Conversely, Abba Lerner
considered laissez-faire (free market) capitalism was akin to letting the car zigzag all over the road. His work
emphasised the fact that if the government desired the economy to develop in a stable way then it had to control
its movement with fiscal and monetary policy.
There are other functions of taxation that governments may focus on. For example, it might desire to alter the
allocation of resources such that people spend less on harmful products (such as tobacco or carbon-intensive
products). Taxes on these type of products pushes their price up and discourages spending on them. While
important we will not consider these microeconomic functions of taxation any further in this text book.
You will be now thinking about the functions or purpose of taxation in a different light, rather than considering
it to be a source of revenue for government that permits it to spend.
We extend this thought process to see how taxation and the incidence of mass unemployment are intrinsically
related in a monetary economy. In such an economy, taxation functions to promote offers from private
individuals to government of goods and services in return for the necessary funds to extinguish the tax
liabilities. This involves the direct offer of labour to the public sector (to allow public production to take place)
as well as privately-produced goods that are purchased by the government to advance its socio-economic
programs.
An example of the latter might be the purchase of construction services from a private construction company to
facilitate the building of a new public hospital. It might manifest as the supply of stationary to the public
schooling system or the supply of technology to a public broadcaster. The private sector supplies a myriad of
goods and services to the government every day and in return, as well as generating income it gains the capacity
to relinquish its tax liabilities.
This train of thought leads to the insight that taxation is a way that the government can elicit productive
resources and final goods and services from the non-government sector that it needs to advance its political
mandate.
It is clear that the non-government sector has to get the dollars before it can pay its tax bills. Where else could
the non-government sector get the dollars from to meet its legal liabilities to the government, if the latter did not
purchase goods and services provided by the non-government sector or make transfers to that sector?
So the reality is the opposite of the intuitive view that conceives of taxation as providing revenue to the
government, which permits it to spend. In fact, government spending provides revenue to the non-government
sector which then allows them to extinguish their taxation liabilities. So the funds necessary to pay the tax
liabilities are provided to the non-government sector by government spending.
Extending that logic leads to a further insight, which we introduced in Chapter 3. The imposition of the taxation
liability creates a demand for the government currency in the non-government sector which allows the
government to pursue its economic and social policy program.
So in our 2 person economy, the government person would be able to purchase labour from the non-government
person as long as the tax regime was legally enforceable. The non-government person will also accept the
government money because it is the means to get the dollars necessary to pay the taxes due.
This insight allows us to see another dimension of taxation which is typically not well understood. Given that
the non-government sector requires fiat currency to pay its taxation liabilities, in the first instance, the
imposition of taxes (without a concomitant injection of spending) by design creates unemployment (people
seeking paid work) in the non-government sector.
The unemployed or idle non-government resources can then be utilised through government spending, which
amounts to a transfer of real goods and services from the non-government to the government sector.
While real resources are transferred from the non-government sector in the form of goods and services that are
purchased by government, the motivation to supply these resources is sourced back to the need to acquire fiat
currency to extinguish the tax liabilities.
Further, while real resources are transferred, the taxation provides no additional financial capacity to the
government of issue.
Conceptualising the relationship between the government and non-government sectors in this way makes it clear
that it is government spending that provides the paid work which eliminates the unemployment created by the
taxes.
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Generalising this discussion, makes it possible to see why mass unemployment arises. It is the introduction of
state money (defined as government taxing and spending) into a non-monetary economy that creates the
possibility of mass unemployment.
As we saw in Chapters 7 and 8, where we developed the expenditure-income framework and the concept of
effective demand, it is a matter of accounting that if all the aggregate output produced in a period is to be sold,
then total spending must equal the total income generated in production (whether actual income generated in
production is fully spent or not in each period).
The obvious conclusion is that unemployment occurs when net government spending is too low to allow taxes
to be paid. In addition, net government spending is required to meet the private desire to save (accumulate net
financial assets).
[NOTE THIS SECTION WILL FINISH BY INTRODUCING OVERALL SPENDING AND THE WAY THE
GOVERNMENT CAN OVERCOME FLUCTUATIONS IN NON-GOVERNMENT SPENDING TO AVOID
ANY SPENDING GAPS AND UNEMPLOYMENT ARISING}
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11.3
What is Full Employment?
In Chapter 1, we learned that a primary macroeconomic goal is full employment of labour resources. That goal
was developed further in Chapter 10 The Labour Market where full employment was related, at the
macroeconomic level with the concept of the “efficiency frontier”.
An economy cannot be efficient if it is not using the resources available to it to the limit. The task of this Section
is to outline in more specific terms what we mean by full employment. For example, does it mean zero
unemployment? If some unemployment is consistent with full employment, what is the threshold beyond which
we depart from full employment?
Given the discussion in Chapter 10 on underemployment and hidden unemployment, does the concept of full
employment require there be no underemployment and no hidden unemployment? If so, then it extends beyond
the concept of persons employed to embrace wider considerations of the hours of employment available.
Does the concept of full employment also take into account the quality of the job, which we considered to be a
consideration as to whether a person was underemployed or not.
In this Section we will consider all these questions.
The concern about full employment was embodied in the policy frameworks and definitions of major
institutions in most nations at the end of the Second World War. The challenge for each nation was how to turn
its war-time economy, which had high rates of employment as a result of the prosecution of the war effort, into a
peace-time economy, without sacrificing the high rates of labour utilisation.
The challenge and aspiration was articulated in the advanced nations in the immediate post war period in the
form of White Paper statements. A – White Paper – is considered to be major statements of policy purpose and
indicate that the government intends to build a legislative and policy framework that will support the pursuit of
the goals outlined.
In 1944, the British Government released its Economic Policy White Paper – which set the post-war policy
agenda that the government proposed.
Its opening statement is (REFERENCE):
The Government accept as one of their primary aims and responsibilities the maintenance of a
high and stable level of employment after the war … A country will not suffer from mass
unemployment so long as the total demand for its goods and services is maintained at a high level
… Total expenditure on goods and services must be prevented from falling to a level where
general unemployment appears.
Note that the intent was to maintain a high level of employment. It was left to the British economist William
Beveridge to define what was meant by full employment.
His 1944 book – Full Employment in a Free Society – he said that full employment (Page 18):
… means having always more vacant jobs than unemployed men, not slightly fewer jobs … It
means that the jobs are at fair wages, of such a kind, and so located that the unemployed men can
reasonably be expected to take them; it means, by consequence, that the normal lag between
losing one job and finding another will be very short.
Today, we would express this in gender neutral terms but the intent would be the same.
Beveridge’s definition does not mean zero unemployment:
Full employment does not mean literally no unemployment, that is to say, it does not mean that
every man and women in this country who is fit and free for work is employed productively on
every day of his or her working life. (REFERENCE)
So he said that full employment would allow for no more than 3 per cent unemployment due to frictions but
there always had to be more vacancies than unemployed workers.
In terms of the categories of unemployment we outlined in Section 11.1, Beveridge split his 3 per cent threshold
into 1 per cent for seasonal factors, 1 per cent for frictional unemployment, and 1 per cent for variations in
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international trade, which disturbed the industrial composition of employment (some have said this is a form of
structural unemployment).
But the important point is that these frictions would never mean that an unemployed worker was in that state for
anything other than a very short period.
The Nobel Prize winning economist William Vickery said in 1993 that full employment is:
… a situation where there are at least as many job openings as there are persons seeking
employment, probably calling for a rate of unemployment, as currently measured, of between 1
and 2 percent. (PAGE REFERENCE)
In terms of the time that was reasonable for a person to remain unemployed, he considered full employment
meant that an unemployed person “can find work at a living wage within 48 hours” (REFERENCE).
Who was responsible for maintaining full employment? Beveridge (1944: 123-135) said:
The ultimate responsibility for seeing that outlay as a whole, taking public and private outlay
together, is sufficient to set up a demand for all the labour seeking employment, must be taken by
the State…
There were other major White Paper-type policy statements in advanced countries that followed the British
White Paper and Beveridge’s book, which defined full employment as a fundamental aim of the national
government.
The wording of these documents was clear – full employment required active government support to ensure that
aggregate demand was sufficient to maintain employment opportunities for all those who desired to work.
It was recognised that the unemployment in the pre-war years was extremely wasteful and as the 1945
Australian White Paper on Full Employment noted:
It is true that war-time full employment has been accompanied by efforts and sacrifices and a
curtailment of individual liberties which only the supreme emergency of war could justify; but it
has shown up the wastes of unemployment in pre-war years, and it has taught us valuable lessons
which we can apply to the problems of peace-time, when full employment must be achieved in
ways consistent with a free society.
The importance of this historical context is to show that the concept of full employment that emerged in the
post-World War 2 period placed the emphasis on jobs. There had to be more vacancies at living wages than
there were unemployed persons looking for jobs. There might be a small proportion of willing workers moving
between jobs but this dislocation would be very temporary.
From the end of the war until the mid-1970s, most advanced governments assumed this responsibility and they
used monetary and fiscal policy to maintain levels of aggregate demand sufficient to ensure enough jobs were
created to meet the demands of the labour force. Unemployment rates were usually very low in this period. In
Australia, for example, the unemployment rate remained below 2 per cent for most of this period.
Figure 11.2 shows the movement in unemployment rates for Australia, the United Kingdom and the United
States from 1950.
[BRIEF DISCUSSION ABOUT THIS DATA AND HOW THE CONCEPT OF FULL EMPLOYMENT
MIGHT TRANSLATE INTO DIFFERENCE FULL EMPLOYMENT UNEMPLOYMENT RATES - THEN A
DISCUSSION ABOUT CYCLES - WHICH WILL LEAD INTO THE THEORETICAL DEBATE AT THE
END OF THIS CHAPTER - AND THE PERSISTENCE OF HIGHER UNEMPLOYMENT SINCE THE 1970s
- LEADING TO A DISCUSSION LATER ABOUT THE ABANDONMENT OF THE WHITE PAPER
COMMITMENTS]
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Figure 11.1
Average Unemployment Rates for Selected Countries by Decade
Source: XXXX
As we will see further on in this Chapter, the emphasis on there being sufficient jobs as a condition for full
employment led to a robust debate about what constituted the irreducible minimum rate of unemployment. How
much frictional unemployment was to be tolerated? What was a fair level of pay?
However, this emphasis gave way in the 1950s to a discussion about the so-called Phillips curve, which was an
postulated relationship between unemployment and inflation. The definition of full employment became tied up
in discussions about whether there was a trade-off between these twin evils (unemployment and inflation) and if
so, what was the extent of that trade-off.
For our purposes, full employment was no longer debated in terms of a number of jobs. Instead it was defined as
the rate of unemployment that was politically acceptable in the light of some accompanying inflation rate.
We will return to that debate later in the Chapter.
In our definition of full employment to date, we have only focused on the number of unfilled jobs on offer
relative to the number of workers who are measured as being unemployed.
In Chapter 10, we learned that the unemployment rate is a narrow measure of labour underutilisation and in
recent decades underemployment has become a significant problem in many countries.
A focus just on jobs ignores the hours-dimension of those jobs in relation to the preferences of the workers who
occupy them. We have seen that underemployment is a form of unemployment in the sense that the worker is
employed but would prefer to work more hours. The problem is not a lack of jobs on offer in this case, but a
lack of hours of work.
Should our definition of full employment take this shortage of hours on offer into account? Logically it should.
The concept of full employment is about efficiency and an underemployed worker is being wasted just as an
unemployed worker is being wasted. The consequences of the waste for the individual might vary – for
example, at least the underemployed worker has an income – but from a macroeconomic perspective, the lack of
working hours leads to foregone national income losses in the same way as joblessness reduces the national
income produced.
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The International Labour Organization (ILO) outlined the policy objective of full employment in their
Employment Policy Convention (ILO No. 122), which was adopted by signatory nations in 1964.
The ILO say (Source) that:
According to this Convention, full employment ensures that (i) there is work for all persons who
are willing to work and look for work; (ii) that such work is as productive as possible; and (iii)
that they have the freedom to choose the employment and that each worker has all the possibilities
to acquire the necessary skills to get the employment that most suits them and to use in this
employment such skills and other qualifications that they possess. The situations which do not
fulfil objective (i) refer to unemployment, and those that do not satisfy objectives (ii) or (iii) refer
mainly to underemployment.
It is clear that our definition of full employment has to evolve to consider the broader ways in which capitalist
societies waste the willing and available labour force.
The ILO clearly considers that full employment should require zero underemployment. That is not the same as
saying that all employment should be full-time. As we learned in Chapter 10, the majority of part-time workers
are content with the hours of work made available to them. However, a growing minority of part-time workers
(up to 30 per cent in some nations) are not content and desire more hours of work.
What about hidden unemployment?
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11.4
Involuntary Unemployment
Another categorisation that economists have used to describe unemployment is to distinguish between the
concept of involuntary and voluntary unemployment. This distinction takes us back to the Great Depression in
the 1930s and the debates between John Maynard Keynes and the Classical economists in Britain during that
period.
The concept of involuntary unemployment follows directly from our notion of full employment as a maximum
employment level that satisfies the preferences of the workers for work.
The idea is that there would be no involuntary unemployment if all persons willing and able to work could find
jobs at the prevailing wages in their desired occupation or skill group.
In The General Theory of Employment, Interest, and Money, John Maynard Keynes said that:
Men 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. (PAGE REFERENCE)
Apart from rendering the gender non-specific, the same definition holds today. But what does it mean? Reading
literally, it invokes a mental experiment where the real wage is reduced as a result of inflation being greater than
the growth in money wages, and one observes firms seeking to hire more labour and workers will to supply
more labour hours.
To understand the significance of this definition we have to first take a detour back into what is known as the
Classical employment theory, which dominated thinking prior to the Great Depression in the 1930s.
The reason we go back in time is because the Classical system provides the context for understanding the
contribution of Keynes and his notion of involuntary unemployment; it allows us to more fully appreciate the
concept of full employment outlined in the previous section; and it allows us to understand the contemporary
debate more clearly where some economists still persist in retaining the discredited Classical notions when
offering policy solutions to unemployment.
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11.5
The Classical Theory of Employment
We can construct the Classical system with the help of a few simple equations and graphs. There are four main
components to the Classical theory of employment, which we will consider in turn:

The Classical labour market, which determines the real wage and total employment level (and
as a result of the labour force being known we also determine the unemployment rate).

A theory of production based on the Law of Diminishing Returns, which links the labour
market with the product market.

A theory of saving and investment which introduces the equilibrating role of the interest rate
and ensures that there can be no aggregate demand shortages.

The Quantity Theory of Money which allows the Classical economists to explain the general
price level.
The Classical theory of employment begins by considering the production function of the individual firm, which
describes how much output the firm will produce for a given labour input, given the stock of capital and other
resources that it has at its disposal.
The Classical system assumes, in the short-run, that the stock (and quality) of capital and other resources (land,
etc) are fixed and the only variable productive input is labour.
This approach makes a very particular assumption about the relationship between labour and output, which is
referred to, by the very important sounding name, as the Law of Diminishing Returns (LDR). While the
invocation of the term “law” might sound authoritative even akin to a natural physical law such as gravity, the
reality is that the idea is a meagre assertion, and only holds true in the rarified atmosphere of the orthodox
textbook. It rarely holds true in the real world of industrial organisations.
According to the LDR, when a firm adds more labour input to the fixed stock of capital, output initially rises but
at a declining rate – that is, the incremental output becomes smaller and smaller as units of labour are employed.
In the language of the classical theory, the marginal physical product of labour is positive but diminishing.
The following diagram plots the Classical production function where real GDP (Y) is on the vertical axis and
total employment is on the horizontal axis.
The convex shape of the “production function” is based on the assertion that there are diminishing returns to
labour. So as more and more labour is added to the production process, the extra output that is forthcoming
diminishes with each extra unit of labour.
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Figure 11.2
The Classical Production Function
Y
Employment
Each firm is assumed to be a profit-maximiser, which means they are interested in assessing the revenue they
can earn from the extra units of output that each extra unit of employment generates relative to the cost that they
incur employing the extra labour.
The Classical model begins by assuming that firms operate in a perfectly competitive product market, which can
be summarised by the statement that each firm is too small to influence the price determined in the market for
output. As a result, every firm is considered to be a price-taker and it can sell as much output as it likes at that
price.
If we assume that the price level is P and the marginal physical product is MP, then the value of the marginal
product (that is, how much revenue the firm can expect to earn at each employment level) is given by VMP =
P.MP, which converts the physical production output into monetary units.
The VMP curve will be downward sloping with respect to employment because of the assertion of diminishing
marginal productivity. The principle of profit maximisation sets rules that govern how much a firm will be
prepared to produce and how many units of labour it will employ.
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Accordingly, the firm seeks to equate the return it receives from selling the last unit of output produced with the
cost of producing that unit of output. We can understand that principle from the perspective of the labour market
as meaning that the firm will employ labour up to the point where the total cost of the last unit of labour
employed exactly equals the value of marginal product (VMP), the latter measuring the revenue the firm gets
from selling the marginal product of the last worker employed.
The firm pays a certain money wage rate (W) to the last worker employed. The profit maximisation rule thus
means that:
(11.1) W = VMP = P.MP
which then can be re-expressed as:
(11.1a) W/P = MP
Thus, a firm will employ labour up to the point where the real wage (W/P) equals the marginal product of
labour.
These concepts form the basis of the Classical labour market, which is the framework that was used to explain
both the prevailing real wage rate and the level of employment. Accordingly, total employment is determined by
the interaction between labour demand and labour supply. Once the total employment is determined, then the
production function tells us how much output will be supplied.
The following equations define the Classical employment and output determination model.
(11.2) Labour demand:
Nd = f(W/P)
f’ < 0
(11.3) Labour supply:
Ns = f(W/P)
f’ > 0
(11.4) Labour Market Equilibrium: Nd = Ns
(11.5) Production Function:
Y = f(N, K*)
Where Y is real output, W is the money wage, P is the price level, K* is constant capital (and other fixed
productive inputs). The production function also assumes that technology is constant.
The terms f’ < 0 and f’ > 0 are the so-called first derivatives of the respective functions which we learned about
in Chapter 4 Methods, Tools and Techniques. For our purposes here, they tell us about the slope of the
respective functions – that is, whether the relationship is an increasing or decreasing function of the real wage.
We conclude that the labour demand function is assumed to slope downward with respect to the real wage (f’ <
0), whereas the labour supply is assumed to slope upwards with respect to the real wage (f’ > 0).
Equations (11.2), (11.3) and (11.4) effectively mean that the Classical approach consider that the labour market
– the equilibration of labour demand and labour supply – determines both the real wage and total employment.
The real wage is considered to be determined in the labour market, that is, exclusively by labour demand and
labour supply. Keynes showed that this assumption is clearly false. It is obvious that the nominal wage is
determined in the labour market and the real wage is not known until producers set prices in the product market
(that is, in the shops etc).
Figure 11.3 shows the Classical labour market equilibrium, where the labour demand and labour supply
determine the equilibrium real wage (W/P*) and employment level (N*). The Classical economists considered
this level of employment to represent full employment because at that W/P* level, all firms that wanted to
employ labour could find sufficient workers and all workers who desired to work could find a firm willing to
employ them.
They considered this would be the state that the labour market would gravitate to if the real wage was flexible.
As we will see, prior to the Great Depression, departures from this “fully employed” state were only considered
to be possible if the real wage was not allowed to move to the equilibrium level (W/P*).
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Figure 11.3
The Classical Labour Market Equilibrium
W/P
NS
W/P*
ND
N*
Employment
In part, the equilibrium solution of the Classical model required that the labour demand function be downward
sloping and the labour supply function be upward sloping with respect to the real wage to ensure they
intersected.
Why is the labour demand function downward sloping?
Why is the labour demand function (Nd) downward sloping with respect to the real wage? Equation (11.1a)
showed that a profit maximising firm will employ labour up to the point that the real wage is equal to the
marginal product.
Given the assertion of the law of diminishing returns, the marginal product declines as employment rises.
Therefore to employ more workers, who are producing less at the margin than the last unit of labour employed,
the firm will only be prepared to pay a lower real wage rate.
Another way of thinking about this is that the firm has to pay the real wage (which is an equivalent amount of
actual product) to the marginal workers and so they will only hire extra labour if the amount the worker
contributes to production is more than the real wage. The assertion of diminishing returns assures the demand
curve will be downward sloping – so the firm will only be prepared to hire extra workers if the real wage is
reduced.
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The firm will stop employing at the point where the real wage is equal to the marginal product. This means that
the current state of technology helps explain the position of the labour demand curve. If, for example, the firm
invested in more efficient capital, then the production function would shift upwards and the each worker would
become more productive. As a result, the labour demand function would shift outwards.
Why is the labour supply function upward sloping?
The upward slope of the labour supply curve means that workers will only be willing to supply more labour if
the real wage rises. Why would the Classical economists make that assumption?
The Classical labour supply function (Ns) is based on the idea that the worker has a choice between work (a
bad) and leisure (a good), with work being tolerated only to gain income. The relative price mediating this
choice (between work and leisure) is the real wage which measures the price of leisure relative to income. That
is an extra hour of leisure “costs” the real wage that the worker could have earned by working for that hour. So
as the price of leisure rises the willingness to enjoy it declines.
Just as the firm is considered to be a profit maximiser, so the worker is assumed to be a utility maximiser such
that the satisfaction (utility) he/she derives from an extra hour of leisure (not working) is exactly equal to the
satisfaction the worker gains from an extra hour of work and the goods and services that the subsequent income
would purchase.
The worker is conceived of at all times making very complicated calculations based on a coherent hour by hour
schedule which calibrates how much dissatisfaction he/she gets from working and how much satisfaction
(utility) he/she gets from not working (enjoying leisure).
The real wage is the vehicle to render these two competing uses of time compatible at a work allocation where
the worker maximises satisfaction.
The Classical analysis motivates the following thought experiment as an attempt to explain what happens when
the real wage changes. They assume that the total change can be decomposed into two separate “effects”: (a) a
substitution effect; and (b) an income effect.
The substitution effect refers to the impact on the worker’s decision to supply hours of labour when the real
wage changes. So if the real wage rises, work becomes relatively cheaper (compared to leisure) and the
mainstream theory asserts via the so-called law of demand, that people demand less of a good when its relative
price rises. So real wage up, less leisure, more work.
However, when the real wage rises, the worker now has more income for a given number of hours of work. The
Classical theory then invokes the notion of a normal goods, which are more in demand as income rises (as
opposed to an inferior good).
The Classical theory assumes that leisure is a normal good as are other consumption goods the worker might
buy with the income he/she earns. As a consequence, as the real wage rises, the income effect suggests that the
worker will demand more of all normal goods (because they have higher incomes for a given number of
working hours) including leisure. That is the worker will work less!
Therefore, within this theoretical framework, the substitution effect predicts the worker will supply more (less)
hours of work when the real wage rises (falls), whereas the income effect, predicts that the worker will supply
less (more) hours or work when the real wage rises (falls).
With the two effects working in opposite directions, what determines the overall effect? The conclusion is that
despite the mathematical form of the Classical theory of employment and the pretension of analytical rigour, the
theory cannot tell us unambiguously which of these two effects dominates.
The result is that the theory asserts that the substitution effect dominates the income effect, which means the
labour supply function slopes upwards with respect to the real wage.
The reason they make this assertion is because if the labour supply function didn’t slope upward it might not
intersect with the labour demand function, which would then mean that the framework would not have a
coherent theory of employment.
[MORE TO COME]
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11.6
Unemployment in The Classical Labour Market
Imagine that for some reason, the real wage was at (W/P)1. We show this in Figure 11.4. This is a departure
from the current equilibrium at W/P*, N*.
Figure 11.4
Unemployment in the Classical Labour Market
W/P
W/P1
NS
A
Unemployment
B
W/P*
ND
N D1
N*
NS1
Employment
Workers are attracted by the higher real wage and are prepared to offer more hours of work (Ns 1) because the
price of leisure has risen and so they substitute away from the relatively more expensive good.
Firms, however, reduce their demand for labour (ND1) in order to seek a higher marginal product of labour.
The general rule is that the “short-side” of the market is dominant in disequilibrium situations, which in this case
means that total employment would be at A while the labour supply would be at B. The difference (B – A)
measures the excess supply of labour at W/P1 or unemployment.
So unemployment can only arise in the Classical system if the real wage is above the equilibrium real wage.
From a macroeconomic perspective, the Classical theory of employment denied the existence of involuntary
unemployment.
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You might argue that the government minimum wage legislation was not the choice of the workers and so in
that sense, the unemployment that the Classical system generates from an excessive minimum wage would not
be voluntary. The response would be that the workers could normally place political pressure on the government
to reduce or scrap the minimum wage – the ultimate pressure being to vote them out of office.
For the Classical economists of the 1930s, this state would be temporary unless there were institutional
rigidities, which prevented the real wage from falling. Why?
They believed that if the labour market was left to adjust on its own accord, the excess supply of labour would
start to drive the price down until the labour market equilibrated at the equilibrium at W/P*, N*.
In that sense, the unemployment (B – A) would be considered temporary.
There was recognition that institutional forces could prolong that adjustment. For example, trade unions might
prevent the real wage from falling back to the equilibrium value at W/P*. In this case, the unemployment would
be considered voluntary because workers could choose to refuse union membership and offer themselves at the
lower wages outside of any wage floors the union might try to enforce.
Another often-used example is the imposition of a minimum wage by the government, which might force the
real wage to be higher than the equilibrium real wage. The solution to the unemployment in that case is for the
government to eliminate the minimum wage and allow the equilibrium real wage W/P* to reassert itself.
In other words, unemployment could not exist in the Classical employment theory if real wages were flexible in
both directions and were allowed to adjust to balance the forces of supply and demand.
It goes without saying that a real wage below the equilibrium W/P* would result in an excess demand for
labour, which would force the real wage to rise back to W/P*, thus eliminating any imbalance.
By way of summary, the Classical theory of employment argues that:

The Labour Supply function represents the preferences of workers between work (a bad) and
leisure (a good), while the labour demand function is determined by the current state of
technology (which determines labour productivity).

Profit maximising firms set the real wage equal to the marginal product, which determines
how much labour they are prepared to employ. The real wage is also the opportunity cost of
leisure for the worker, and when the real wage rises (falls) the workers supply more (less)
labour.

The interaction between the labour demand and supply functions determines the equilibrium
real wage and employment level in each period.

rm) is thus a technological mapping from the equilibrium employment determined by the
equilibrium relationship into the production function.

The existence of unemployment is due to the real wage being above the equilibrium real wage
that would be established by the intersection of labour demand and labour supply.

Real wage flexibility would ensure that such unemployment was of a temporary nature.

Changes in the preferences of the workers towards work (which shift the labour supply curve
in or out) and/or changes in technology which sift the labour demand curve (in or out) change
the equilibrium real wage and employment level. As a consequence, these changes would lead
to a change in the level of employment that was considered to constitute full employment.
Given real wage flexibility, departures from full employment are ephemeral at best. Any
sustained unemployment must be due to a real wage constraint imposed on the market.
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11.7
What is The Equilibrium Output Level?
It should be clear from the previous analysis that the level of employment and the real wage is determined in the
labour market within the Classical system.
In turn, once the equilibrium level of employment is determined, the equilibrium level of output (real GDP) is
also determined given the available technology. The latter determines the shape and position of the production
function.
Figure 11.5 brings together the Classical labour market and the production function. You can see that the
equilibrium level of employment generates a particular output level (Y*) which then constitutes the aggregate
supply for the economy.
Figure 11.5
Classical Equilibrium Output Determination
Y
Y*
Employment
NS
W/P
W/P*
ND
N*
Employment
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The next question we have to ask is: What guarantees that the flow of real GDP produced (Y*) will be sold each
period?
In other words, why is this an equilibrium level of real output?
What did the Classical system invoke to ensure that the labour market equilibrium with no excess supply or
demand, would be consistent with a product market equilibrium where aggregate demand for goods and services
was equal to aggregate supply (Y*)?
The answer is that they developed the loanable funds theory, which ensures that saving and investment are
always equal.
11.8 The Loanable Funds Market – Eliminating the Possibility of an
Aggregate Demand Deficiency
The Classical theory adopted the view that there could be no general deficiency in planned aggregate spending,
which would leave total productive capacity idle.
They admitted that specific goods and services could be “over-produced” but believed that rapid market
adjustments would ensure there could never be a generalised glut or ever occur.
The denial that generalised over-production could occur has become known as “Say’s Law” after the French
economist Jean-Baptiste Say, who popularised the view.
The idea is sometimes summarised by the epithet – “supply creates its own demand”. The logic is that by
supplying goods and services into the market, beyond the output intended for own-use consumption, producers
are signalling a desire to exchange their surplus output for other goods supplied into the market.
In other words, everything that is supplied is simultaneously a desire to demand (for own-use or for exchange).
Using the terminology developed in Chapter 9, and assuming for simplicity a closed economy without a
government sector, which is the typical depiction of the Classical system, we know that the total flow of
spending in the economy is in equilibrium equal to total real GDP and national income (Y).
Total spending is the sum of consumption (C) and investment (I):
(11.6) Y = C + I
Equilibrium requires that real output (Y) is sold each period.
National income is either consumed (C) or saved (S) which allows us to write:
(11.7) Y = C + S
In equilibrium:
(11.8) C + I = C + S
Which means that the equilibrium condition is S = I, or planned saving is equal to planned investment. This
means that all goods designed to be consumed are sold and the remaining national income is equal to investment
(designed to provide for future consumption).
So the Classical system allowed for a desire to save in any period, but argued that the withheld consumption
would be matched by (planned) investment spending given that the saving was just a signal that consumers
wanted to consume in the future.
From an existing equilibrium, imagine that the desire to save rose. Consumption would fall in the current period
and to maintain the equilibrium output level planned investment would have to rise.
What mechanism exists that would bring planned saving and planned investment into equality each period to
allow for shifts in, for example, consumer behaviour (a rise in the desire to save in this case)?
Ignoring questions relating to the logistics of how an economy might quickly shift between the production of
consumption and investment goods, the answer lay in the way the loanable funds market operated.
The theory of loanable funds provided the Classical system with the vehicle to explain how aggregate demand
could never fall short of aggregate supply. The continuous equilibration would be achieved by interest rate
adjustments, which would always bring planned saving and planned investment into equality as household and
firms preferences changed.
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The loanable funds market is really a primitive depiction of a financial system.
Savers (lenders) enter the market to see a return on their savings to enhance the future consumption possibilities.
Equally, firms seeking to invest (borrowers) enter the loanable funds market to get loans.
The interest rate that is determined in this market provides the return to households for their saving and
determines the cost of borrowing funds for investment.
The following diagram shows the market for loanable funds. The supply of funds comes from those people who
have some extra income that they want to save and lend out. As the interest rate rises, the return on saving rises
and so the supply of funds (saving) rises.
The demand for funds comes from borrowers who wish to invest in houses, factories, and equipment among
other productive projects. As the cost of borrowing (the interest rate) rises, the demand for funds falls because
the net return on the planned projects diminishes.
The interest rate adjusts to ensure the supply of funds (saving) equals the demand for loans (investment). In
Figure 11.6, the equilibrium interest rate is 5 per cent.
[NOTE: We will render this rate i* in the final text to generalise it and change the text accordingly]
If the interest rate was below the equilibrium rate then the volume of funds demanded from the loanable funds
market by would be borrowers would exceed the supply of loanable funds and competition among the borrowers
would force the interest rate up. As the interest rate rises, planned saving would increase and planned investment
would decline. At the equilibrium interest rate, the imbalance between supply and demand would be eliminated
and planned saving would equal planned investment.
The converse then follows if the interest rate is above the equilibrium.
Figure 11.6
Loanable Funds Equilibrium
[TO BE CONTINUED ...]
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11.8
The Loanable Funds Market – Classical Interest Rate Determination
The Classical theory of interest rate determination provided them with a mechanism for denying the possibility
that there could be a generalised deficiency in planned aggregate spending, which would result in idle
productive capacity and persistent unemployment.
They admitted that specific goods and services could be “over-produced” relative to the preferences of the
consumers and firms but believed that rapid market adjustments would ensure there could never be a generalised
glut.
The denial that generalised over-production could occur has become known as “Say’s Law” after the French
economist Jean-Baptiste Say, who popularised the view.
The idea is sometimes summarised by the epithet – “supply creates its own demand”. The logic is that by
supplying goods and services into the market, beyond the output intended for own-use consumption, producers
are signalling a desire to exchange their surplus output for other goods supplied into the market.
Using the terminology developed in Chapter 9, and assuming for simplicity a closed economy without a
government sector, which is the typical depiction of the Classical system, we know that in equilibrium, the total
flow of spending in the economy is equal to total real GDP and national income (Y).
Total spending is the sum of consumption (C) and investment (I):
(11.6) Y = C + I
Equilibrium requires that the flow of real output (Y) is sold in each period.
National income is either consumed (C) or saved (S) which allows us to write:
(11.7) Y = C + S
In equilibrium:
(11.8) C + I = C + S
Which means that the equilibrium condition is S = I, or planned saving is equal to planned investment. This
means that all goods designed to be consumed are sold and the remaining national income is equal to investment
(designed to provide for future consumption).
The Classical system considers that withheld consumption in each period is matched by (planned) investment
spending given that the saving is just a signal that consumers wanted to consume in the future. Firms are thus
assumed to invest in future productive capacity to ensure they can meet that demand.
From an existing equilibrium, imagine that the desire to save rose. Consumption would fall in the current period
and to maintain the equilibrium output level planned investment would have to rise.
What mechanism exists that would bring planned saving and planned investment into equality each period to
allow for shifts in, for example, consumer behaviour (a rise in the desire to save in this case)?
Ignoring questions relating to the logistics of how an economy might quickly shift between the production of
consumption and investment goods, the answer lay in the way the loanable funds market operated.
The theory of loanable funds – which is the Classical theory of interest rate determination – provided the
Classical system with the vehicle to explain how aggregate demand could never fall short of aggregate supply.
The continuous equilibration would be achieved by interest rate adjustments, which would always bring planned
saving and planned investment into equality as household and firms preferences changed.
The loanable funds market is really a primitive depiction of a financial system. The interest rate (r) is a price that
ensures that planned investment is equal to planned saving in any period and is determined within the loanable
funds market.
Savers (lenders) enter the market to seek a return on their savings to enhance the future consumption
possibilities. Equally, firms seeking to invest (borrowers) enter the loanable funds market to get loans.
The interest rate that is determined in this market provides the return to households for their saving and
determines the cost of borrowing funds for investment.
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The following diagram shows the market for loanable funds. The supply of loans is derived from current saving
which is assumed to be positively related to the interest rate. As the interest rate rises, the return on saving rises
and so the supply of funds (saving) rises (and current consumption falls).
The demand for funds comes from borrowers who wish to invest in houses, factories, and equipment among
other productive projects. Firms form expectations of future returns that they will derive from different projects
and rank the profitability of projects for the current cost of funds. As the cost of borrowing (the interest rate)
rises, the demand for funds falls because the net return on the planned projects diminishes.
In other words, the demand for loans (investment) is negatively related to the rate of interest. The higher the rate
of interest, other things equal, the lower will be investment.
The interest rate adjusts to ensure the supply of funds (saving) equals the demand for loans (investment). In
Figure 11.6, the equilibrium interest rate is r* per cent, and this corresponds with equilibrium saving (S*) and
investment (I*).
If the interest rate was below the equilibrium rate then the volume of funds demanded from the loanable funds
market by would be borrowers would exceed the supply of loanable funds and competition among the borrowers
would force the interest rate up. As the interest rate rises, planned saving would increase and planned investment
would decline. At the equilibrium interest rate, the imbalance between supply and demand would be eliminated
and planned saving would equal planned investment.
The converse then follows if the interest rate is above the equilibrium.
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11.6
Classical Interest Rate Determination
r
Supply of
loans (S)
r*
Demand for
loans (D)
S*, I*
Quantity of Funds
Figure 11.7 shows the impact on the interest rate and the equilibrium level of saving and investment when
households decide to consume more of their income in the current period. In this circumstance, the Supply of
Loans (S) shifts to the left (say to S2).
At the previous equilibrium interest rate r*, there is now an excess demand for loans equal to the distance AB.
Competition for the scarce funds drives the interest rate up and a new equilibrium is established at r*2 per cent,
and this corresponds with equilibrium saving (S*2) and investment (I*2).
You should be very clear that the real GDP level does not change as it is determined by the real wage and
employment equilibrium set in the labour market.
What changes in the Classical system is the composition of final expenditure and output rather than the total
flow. The lower saving is replaced by higher consumption and investment contracts accordingly.
You might also wonder how an economy could make these shifts quickly given that production of consumption
goods and services would require a different mix of capital than the production of capital goods. We will discuss
that point later.
You should now be able to articulate a story of what might happen should the borrowers expect stronger
revenue flows from investment projects or consumers become more cautious and decide to save more of their
income.
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Figure 11.7
Increased Desire for Consumption
r
S2
Supply of
loans (S)
r*2
r*
Demand for
loans (D)
S*2, I*2
S*, I*
Quantity of Funds
As a final observation, the Classical system considered the interest rate to be a real variable which adjusted to
bring real aggregate demand into line with aggregate supply (via the loanable funds market).
Thus the entire real side of the simple economy is explained in the Classical system without reference to money.
Real GDP, national income, employment, the real wage and the interest rate are all determined in the Classical
system once we know the state of technology and the preferences of households between work and leisure and
consumption and saving.
As we will see, the only function the introduction of money serves in the Classical system is to determine the
aggregate price level (and the inflation rate). In the economics literature this separation in the explanation of the
real side of the economy and the nominal side (price level determination) is referred to as the classical
dichotomy.
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11.9
Classical Price Level Determination
To complete the Classical system, we consider their conception of aggregate demand, which allows the system
to determine an aggregate price level.
With the output level once the real wage and employment is determined in the labour market, and the loanable
funds doctrine ensures that real aggregate demand will be sufficient to absorb that level of output, the question
that remains is how are the nominal variables in the Classical system determined?
The two key nominal variables are the aggregate price level and the money wage rate. The determination of the
money wage follows once we know the price level because the real wage is just the ratio of nominal wage to the
price level.
The Classical system explains the determination of the price level by reference to the Quantity Theory of
Money. Money is exclusively a means of exchange to overcome the problem of double-coincident of wants in
traditional barter models. For example, a plumber who desires the services of an electrician, no longer has to
find an electrician who simultaneously desires the services of the plumber.
A given nominal stock of money (Ms), which is a sum of dollars, is considered to be moved between individuals
as various transactions are made during some period. The number of times the stock of money turns overs each
period in the course of these transactions is called the velocity of circulation (V).
The product of the stock of money and the velocity of circulation (MsV) must therefore equal the total nominal
value of real output in a given period. The total nominal value of output is the product of real output (Y) times
the price level (P). You will note that this is the definition of current price GDP, which we analysed in Chapter
6.
The Quantity Theory of Money is thus captured by the following expression:
(11.9) MsV = PY
The product MsV is a nominal amount and represents total nominal aggregate demand in a given period,
whereas the product PY represents the nominal value of aggregate supply in the same period.
The Classical system assumed that V was constant, being determined by spending habits and other shopping
customs (including the time of wage and salary payments).
Further, given that the Classical system assumes that the real side of the economy is determined without
reference to the stock of money and that real wage flexibility ensures that full employment output will be
supplied in each period (as a result of continuous labour market clearing), then Y is also assumed to be fixed in
each period.
It becomes clear from Equation (11.9) that if V and Y are fixed, then changes in Ms will cause changes in P.
The Classical system also assumed that the central bank controlled the nominal stock of money in circulation
and thus were in a position to determine the nominal value of total spending.
In Chapter 15 Money and Banking, we will examine the concept of the money multiplier, which is the theorem
that the Classical system relies upon for their assumption that the central bank can control the money supply.
We will learn that in the real world, the assumptions that underpin the concept of the money multiplier do not
hold and that the central bank is unable to control the stock of money in the economy at any point in time.
But for now, we continue to assume that the central bank can control Ms. It follows that with the real variables
determined in the labour market, the only variable that the central bank (government) can influence is the price
level.
This idea resonates throughout the history of economic thought and as we will see later in the Chapter when we
consider the Phillips curve, it led to the current policy resistance to the use of fiscal policy and the promotion of
monetary policy as the primary counter-stabilising policy tool.
It follows logically that if V and Y are fixed in any period, then if the central bank was to accelerate the growth
in the money supply (Ms) then all it would accomplish was an accelerating growth in the price level, which we
call inflation. This theory thus became the central authority for the claims that inflation is caused by lax
monetary policy.
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11.10 Summary of The Classical System
The simplified Classical system has the following features:

The labour market is continuously cleared as a result of real wage flexibility.

Labour demand is determined by the state of techology, which is embodied in the production
function and labour supply is determined by the preference by workers for income and leisure.
The real wage is the price of leisure.

The real variables in the Classical economy – real wage, employment, real GDP and the
interest rate – are thus simultaneously determined by the labour market clearance.

The nominal side of the economy – the price level and money wage level – are determined by
the stock of money that the central bank is assumed to control. The more money there is in the
economy relatively to the given real output, the higher is the price level.

There can be no involuntary unemployment in this system because real wage flexibility
ensures that a continuous state of full employment is maintained. Any persistent
unemployment must be due to real wage rigidities that prevent it from adjusting to the
respective labour demand and labour supply conditions.

The only effective role for government policy is to ensure the money supply growth is not
excessive and to ensure that the labour market is flexible so that the real wage can balance
demand and supply.
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11.11 Pre-Keynesian Criticisms of The Classical Denial of Involuntary
Unemployment
Understanding the meaning of involuntary unemployment requires a prior understanding of the concept of
effective demand, which we discussed in Chapters 8 and 9.
The 1936 publication of – The General Theory of Employment, Interest, and Money – by John Maynard Keynes
is credited by most as providing the definitive analysis of the concept of effective demand. Later in this Chapter
we will consider how Keynes attacked the Classical view that the real outcomes of the economy were
determined by the full employment equilibrium achieved in the labour market via real wage flexibility.
However, the essential elements underpinning the critique of Say’s Law and the modern understanding of
involuntary unemployment in a monetary capitalist economy can be found in the work of Karl Marx,
particularly in his – Theories of Surplus Value.
Marx, in particular, provided a strong critique of Classical economist David Ricardo, who in his major work –
On the Principles of Political Economy and Taxation – had championed the ideas of J.B Say, which denied the
possibility of generalised over-production in a monetary economy.
In Theories of Surplus Value, Marx launched an attack on Say’s Law, which is the proposition that there could
be no general overproduction in a capitalist economy. Marx was intent on showing that a money-using,
capitalist economy was prone to economic crises (which we now call recessions) and that unemployment was a
inherent tendency of such a system.
Marx was thus opposed to the Classical denial that persistent unemployment could occur. He noted that in
denying the possibility of a general glut, Ricardo assumed that consumers had unlimited needs for commodities
and any particular saturation (having too much of one good or service) would be quickly overcome by increased
demands for other commodities.
Marx started from the proposition that capitalists aim to accumulate ever increasing wealth by extracting surplus
value, which is production value in excess of what the workers receive in the form of wage payments. The
generation of profit thus requires two actions: (a) surplus value creation as the object of production which aims
to reduce the payments to labour (limit their consuming power); and (b) Sale of commodities in market which is
limited by the consuming power of society.
So Marx quickly established the inherent contradiction in capitalism and deemed this the precondition for crises.
On the one hand, capitalists sought to repress the growth of wages and increase the work effort because that was
what allowed them to maximise surplus value. But on the other hand, they could only realise that surplus value
as money profits if they could subsequently sell the product and the repression of the wage income undermined
their chances of achieving that.
Say’s Law was best summarised by Ricardo (1821) (in Chapter XX1, Effects of Accumulation on Profits and
Interest, of his Principles, Pages 192-3):
M. Say has, most satisfactorily shown that there is no amount of capital which may not be
employed in a country because a demand is only limited by production. No man produces but
with a view to consume or sell, and he never sells but with an intention to purchase some other
commodity, which may be immediately useful to him, or which may contribute to future
production. By producing, then, he necessarily becomes either the consumer of his own goods, or
the purchaser and consumer of the goods of some other person. It is not to be supposed that he
should for any length of time be ill-informed of the commodities which he can most
advantageously produce to attain the object which he has in view, namely the possession of other
goods; and therefore it is not probably that he will continually produce a commodity for which
there is no demand.
Marx started from the observation that Say’s Law was refuted by the fact that crises occur in the real world.
Marx saw that sale and purchase are separate actions with separate motivations. He showed that Say’s Law can
only hold in barter which denies the essential features of a monetary capitalism.
In barter you may consume your own good whereas in capitalism Marx said that “no man produces with a view
to consume his own product” [FIND EXACT REFERENCE]. A capitalist must sell and crises occur when sales
cannot be made or only at prices below cost. A capitalist may have produced in order to sell (Say’s Law) but if
sales cannot be made how does this help?
Ricardo’s (1821) retort was that (Chapter XXI,1 p. 24):
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… he never sells, but with an intention to purchase some other commodity, which may be
immediately useful to him, or which may contribute to future production …
To which Marx responded by saying “What a pleasant portrayal of bourgeois relations!” [FIND EXACT
REFERENCE] It was clear to Marx that capitalists aim to sell to transform commodities back into money and
realise profits. Consumption is not the aim of the capitalist. He said that only the workers sell commodities
(labour power) to consume.
Marx focused on the special role that money plays and demonstrated that it is more than a “means of exchange”.
It is the medium by which the exchange of commodities falls into two separate acts which are independent of
each other and separate in space and time. This is the key to understanding crises in capitalism.
The break between production and realisation can occur because of this separation. For example, the existence
of the chain of production and lines of credit means that a merchant may buy cloth on credit, and the farmer
sells to spinner, spinner to weaver etc. If the merchant cannot sell, no-one in chain is paid.
Marx’s argument established for the first time that crises manifest as monetary phenomena and mass
unemployment was not a voluntary outcome.
Ricardo (Chapter XXI, p.194) said:
… too much of a particular commodity may be produced, of which there may be such a glut in the
market as to not repay the capital expended on it; but this cannot be the case with respect to all
commodities.
But Marx showed that all commodities can be in oversupply except money. The necessity for a commodity to
transform itself into money means only that the necessity exists for all commodities. It is the general nature of
the Money-Commodity-Money process that includes the separation of purchase and sale and their unity which
invokes the possibility of a general glut.
Ricardo tried to counter this view (Chapter XXI, p. 194):
The demand for corn is limited by the mouths which are to eat it, for shoes and coats by the
persons who are wear them; but though a community, or a part of a community, may have as
much corn, and as many hats and shoes as it is able or may wish to consume, the same cannot be
said of every commodity produced by the nature or by art. Some would consume more wine if
they had the ability to procure it. Others, having enough of wine, would wish to increase the
quantity or improve the quality of their furniture. Others might wish to ornament their grounds, or
to enlarge their houses. The wish to all or some of these is implanted in every man’s breast;
nothing is required but the means, and nothing can afford the means but an increase in production.
To which Marx asked – “Can there be a more childish line of reasoning?” Marx noted that when there is
overproduction (crises) the workers are “less than ever supplied with grain, shoes, etc., to say nothing of wine
and furniture.” [FIND EXACT REFERENCE]
Marx thus made a crucial distinction that remains relevant in the modern debate. Overproduction has nothing
much to do with absolute needs. The debate is not about whether production can outstrip needs. It is only needs
with capacity to pay that count!
So this was the first real statement of the concept of the principle of effective demand that became central to
Keynes’ work.
Ricardo would say that if a person wanted some shoes then they could acquire the means to buy them by
producing something themselves. But this is a barter economy. So why not just produce the shoes him/herself?
In capitalism, when there is overproduction – goods flood the market. But it is the actual producers (workers)
who suffer from a lack of commodities. It is nonsense to say that they should produce more.
Marx rhetorically asked for an explanation of the connection between “over-production” and “absolute needs”
and indicated that capitalist production is [FIND EXACT REFERENCE]:
… only concerned with demand that is backed by ability to pay. It is not a question of absolute
over-production – over-production as such in relation to the absolute need or the desire to possess
commodities.
Marx’s ideas were thus the precursor to Keynes’ analysis which sought to refute the Classical notion that the
real wage and employment were determined in the labour market. In both Marx and Keynes, we see that actual
employment is determined by the level of effective demand – that is, in the product market.
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Effective demand is the level of output where business profit expectations are consistent with spending plans by
consumers and firms. It was identified that there is a limit on profitable expansion of private output. The level of
effective demand places a ration on the labour market and there is no certainty that this limit will coincide with
full employment, where all workers who want to work can find jobs.
We now turn to the critique of the Classical system provided by Keynes.
[TO BE CONTINUED ...]
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11 JAN BLOG
11.12 The Existence of Mass Unemployment as an Equilibrium Phenomenon
At the outset, the debate between Keynes and the Classical view in the 1930s expressed by the British Treasury
(which became known as the Treasury View) centred on whether a person could become involuntary
unemployed.
The “Treasury View” denied the existence of involuntary unemployment and argued that fiscal policy
(government spending) could not enhance national prosperity by creating employment.
In his 1929 budget speech – (delivered Monday, April 25, 1929 – see Hansard. (1929) HC Deb 15 April 1929,
vol. 227, cc53–6 for details), the then British Chancellor of the Exchequer, Winston Churchill outlined the
“Treasury View” very clearly:
The orthodox Treasury view, and after all British finance has long been regarded as a model to
many countries, is that when the Government borrows in the money market it becomes a new
competitor with industry and engrosses to itself resources which would otherwise have been
employed by private enterprise, and in the process it raises the rent of money to all who have need
of it.
You will readily associate this with our discussion in the previous section of the Loanable Funds Doctrine. In
Chapter 17, we consider the modern debates in macroeconomics in more detail and you will readily see that the
so-called crowding out objections against the use of fiscal policy, that are entertaining in the current era are
based on this Treasury View. In fact, the current attack on the use of fiscal policy to increase employment
growth reflects the conservative position put forward in the 1920s and 1930s, which we have characterised as
the Classical employment theory.
Churchill also denied the fiscal policy would deliver lasting employment gains (REFERENCE):
… the orthodox Treasury doctrine … has steadfastly held that, whatever might be the political or
social advantages, very little additional employment and no permanent additional employment can
in fact and as a general rule be created by State borrowing and State expenditure.
As we saw in Section 11.X, the orthodox approach led to the conclusion that any enduring unemployment
(beyond the frictional level) was caused by real wages being above the equilibrium level, principally because
money wages were downwardly rigid.
[NOTE: The 1929 Budget was labelled an "election budget" yet the conservative government lost the election
that was held soon after it was delivered. In the face of rising unemployment, the British people rejected the
argument that the government was powerless to increase employment].
The Classical (orthodox) cure for unemployment was simple – allow money wages to fall in the face of the
excess supply of labour – so that the real wage could adjust to the “full employment” productivity level. The
only role for government in this process was to ensure that wage flexibility was possible.
John Maynard Keynes disputed this reasoning and outlined a new approach to the labour market, which
provided an explanation for mass unemployment that was independent of whether wages were flexible or not. In
other words, he set out to show that the existence of mass unemployment was not related to the question of wage
flexibility.
In the historical context, this contention was considered to be revolutionary as it challenged the intellectual
supremacy of the conservative economists, who held sway in government.
In developing his explanation for the existence of involuntary unemployment, Keynes sought to show that mass
unemployment arose as a result of systemic failures, which left individuals powerless to improve their own
circumstances.
As a precursor to understanding the specific way in which Keynes developed his new theory, it is important to
consider two broad concepts of equilibrium that can be found in the literature.
In the Classical employment model, we see that equilibrium is commensurate with a point where supply equals
demand. It is also construed as being a point at which the economy will remain at rest if no disturbances to
supply or demand occur. The first construction follows from the second.
Unemployment therefore, in the Classical employment theory, is a dis-equilibrium phenomenon, and will be
eliminated as real wage flexibility restores the demand and supply equilibrium.
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The only way the dis-equilibrium could persist is if, for example, the government imposed rigidities on the
labour market (say, a minimum wage) that held the real wage above the full employment level. Otherwise, the
flexible price labour market would always ensure the full employment equilibrium was sustained.
The concept of involuntary unemployment that Keynes introduced into the literature was consistent with the
concept of equilibrium as being a state of rest. But it was in sharp contradistinction to the idea that equilibrium
also required a balance between demand and supply.
In other words, he advanced an argument that said that mass unemployment was an equilibrium state that the
capitalist monetary economy tended towards and could remain indefinitely without government intervention.
Therefore, the Classical approach saw unemployment as a temporary disequilibrium state, which would be soon
corrected as real wages adjusted to the demand and supply imbalance, whereas Keynes saw unemployment as
being an equilibrium state, which would persist unless effective demand was stimulated.
This distinction also influences the way Keynes defined full employment. For the Classical economist in the
1920s, full employment occurred whenever labour demand and labour supply were equal, irrespective of the
level of employment that coincided with that balance. As you will recall, they denied the existence of
unemployment so that even if the employment level achieved was well below the current labour force, they
would consider the difference to reflect voluntary choices by workers not to work.
For Keynes, full employment was a special point that required that effective demand (total spending) was
sufficient to ensure that there were enough jobs offered to match the willing labour supply at the current money
wage level. It was a state that the capitalist system might achieve (as a special case) but there was no general
tendency within the dynamics of the system to move the economy to this state.
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11.13 Keynes Critique of Classical Employment Theory
In the General Theory of Employment, Interest and Money, (1936) Keynes sought to show that the Classical
theory failed to provide a satisfactory explanation for the existence of mass unemployment. He also rejected the
principle policy proposed by the “Treasury View” that money wages should be cut to solve unemployment.
Keynes also argued that even if real wage flexibility was possible, the economy could still tend to and persist in
a state of mass unemployment. In other words, he sought to demonstrate that the existence of mass
unemployment was not related to whether real wages were flexible or not. As a matter of policy, as we will
explain later, Keynes thought that the existence of money wage rigidity and the institutions that supported it was
a preferred state. But he was at pains to show that unemployment was not caused by that institutional structure.
In Chapter 2 of the General Theory, Keynes introduced what he called the “two fundamental postulates” of
Classical economics (that is, the “Treasury View”):
i. The wage is equal to the marginal product of labour
ii. The utility of the wage when a given volume of labour is employed is equal to the marginal
disutility of that amount of employment.
[Source: Macmillan version GT, 1936, page 5]
You should ensure that you can relate these “postulates” with the discussion in Section 11.5. The first postulate
describes the Classical labour demand theory where profit-maximising firms employed up to the point where the
real wage they paid to the last worker hired was exactly equal to the marginal productivity of that worker.
The second postulate relates to the Classical supply of labour theory that workers choose between work and
leisure. The former provides income, which allows the worker to derive satisfaction (“utility”) from the
purchase of goods and services, but also is considered bad (“a disutility”) because it diverts workers from
enjoying leisure.
The price of leisure is the real wage and workers ensure that the number of hours of work they supply equalises
the good derived from work with the bad.
While Keynes ultimately showed that the real wage and total employment level were not determined in the
labour market, as in the Classical theory of employment, he still had no objection to the first postulate as a
representation of a competitive economy. Later in the Chapter we will see that his acceptance of the first
classical postulate was not without problems.
His main motivation, in accepting the first postulate, was to divert the focus of his critique on the supply side of
the labour market, which he considered was the source of Classical failure to understand how involuntary
unemployment could arise as a normal tendency of the Capitalist monetary economy.
Keynes had two objections to the second classical postulate – one which he said was “not theoretically
fundamental” (REFERENCE) and the other which he described as being “fundamental”.
The first “not theoretically fundamental” objection (GT, 1936, page 12):
… relates to the actual attitude of workers towards real wages and money-wages respectively …
He thus considered this postulate did not accord with the real world behaviour of workers, which, in empirical
terms, suggested that workers behaved in an asymmetric way to real wage reductions, depending on whether
they were motivated by money wage reductions or a rise in the general price level.
He argued that workers would withdraw their labour services if money wages were cut (and real wages fell) but
would not respond in this way, if an equivalent real wage cut resulted from the price level rising. In other words,
as a general case, it is observed that workers do not necessarily withdraw their labour services when the real
wage falls. It all depends on what motivates that reduction.
Recall that the real wage is a ratio of the money wage and the general price level. Keynes argued that the
“classical school have tacitly assumed that this would involve no significant change in their theory” (GT, 1936,
page 8).
The clue to understanding his argument was to note that the Classical model assumed that labour supply was a
function of the real wage exclusively (see Figure 11.3). However, in the real world, workers are also concerned
with the level of money wages as well as the purchasing power equivalent of the same (the real wage).
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The Classical response to this critique was to claim that it is irrational or illogical for workers to suffer from
what they called “money illusion”. That is, why would workers care about the nominal value of their wage.
Surely, it is only the real wage that matters because their decision to supply labour was to acquire real goods and
services from the income they earned?
Keynes response was telling. First, he noted that while a rise in the general price level affected all workers,
money wage cuts would be typically applied to certain segments of the workforce (where unemployment was
concentrated). Research confirms that workers are influenced by their relative place in the wage structure, given
that wages are one way in which we measure social status. One’s money wage is more visible to others than the
more ambiguous concept of the real wage.
At parties and other social milieu, we informally judge each other by the income levels that we receive. These
are concerns that the Classical model ignores.
If a worker in a particular industry was to accept a money wage cut when that industry was enduring a downturn
in demand for its output, then they would be downgrading their position in the wage structure. They would also
form the view that their relative position in the wage structure would not be reversed when the economy
improved again. As a result, these workers will resist a money wage cut.
However, they will not necessarily resist a real wage cut (of the same implied magnitude as would result from
the money wage reduction) arising from a rise in the general price level because this would impact on all
workers and the relative positions in the wage structure would be maintained. They would all be worse off but
not in relative terms.
While the Classical approach ignored the richness of social institutions, thinking of them as ephemeral rigidities
standing in the way of competitive outcomes which would disappear under the force of competition in the longrun, economists like Keynes understood the value of institutions. This made it easy for him to understand that it
was perfectly logical or rational for a worker to be concerned about social standing (relativities).
Keynes also understood that trade unions were important institutions in a Capitalist economy, which protected
the place of workers in the income distribution. He wrote (GT, 1936, page 14) that:
Every trade union will put up some resistance to a cut in money-wages, however small. But since
no trade union would dream of striking on every occasion of a rise in the cost of living, they do
not raise the obstacle to any increase in aggregate employment which is attributed to them by the
classical school.
The second reason why workers would resist cuts to money wages relates to the financial arrangements that
workers enter into in the normal course of their lives. A major commitment that many workers enter is the
purchase of their homes. Further, workers use credit to smooth their consumption expenditure over time. These
contractual commitments are always specified in nominal (that is, money) terms. For example, a worker has to
pay a certain quantity of dollars per month to service their home mortgage.
In other words, the solvency of the workers is a nominal concept. If they cannot get sufficient money each
period to service their nominal contractual commitments then they are in trouble.
In this context, if the general price level rises and the real value of their money wage declines, for a time, they
are able to change their budget allocations (perhaps eliminate some non-necessary items of expenditure) and still
maintain their nominal contractual obligations. At some point, this becomes impossible but within the usual
variations in the real wage this is how households cope.
However, if the real wage was to be adjusted via reductions in the money wage, workers might find they do not
have enough money income in a period to service their contractual obligations and they would then have to
default and face insolvency.
Clearly, it is rational to resist that eventuality and thus workers care not only about the real wage they are able to
earn but also the level of money wages that they receive.
However, Keynes did not consider these institutional objections to be fundamental to the theoretical veracity of
the Classical employment model. He described his second major objection as being a “more fundamental
objection” – that is, it attacked the theoretical basis of the Classical explanation of unemployment.
Keynes (GT, 1936, page 12) characterised the second postulate as flowing:
… from the idea that the real wages of labour depend on the wage bargains which labour makes
with the entrepreneurs … it is the money-wage thus arrived at which is held to determine the real
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wage. Thus the classical theory assumes that it is always open to labour to reduce its real wage by
accepting a reduction in its money-wage.
The Classical model characterises the interaction between labour demand and supply as being mediate by
movements in the real wage, yet in the real world it is the money wage that is agreed in the labour market.
Thus, workers apply for jobs, which specify a certain money wage that will be paid. In some cases, workers
negotiate the money wage they are prepared to accept. The point is that the so-called labour market contract that
leads to a worker taking a job with some employer leads to some money wage being paid to the worker. It might
be $15 per hour or $80,000 per year or whatever.
To argue that unemployment is voluntary and can be solved by a reduction in the real wage assumes that
workers have volition and can engineer the appropriate real wage cut by accepting lower money wages. This
would require “that the wage bargains between the entrepreneurs and the workers determine the real wage”
(page 13).
Keynes disputed the claim (GT, 1936, page 13):
… that the general level of real wages is directly determined by the character of the wage bargain.
In assuming that the wage bargain determines the real wage the classical school have slipt in an
illicit assumption. For there may be no method available to labour as a whole whereby it can bring
the general level of money-wages into conformity with the marginal disutility of the current
volume of employment. There may exist no expedient by which labour as a whole can reduce its
real wage to a given figure by making revised money bargains with the entrepreneurs. [emphasis
in the original]
Keynes believed that the Classical economists had fundamentally misunderstood how “the economy in which
we live actually works” (GT, 1936, page 13). In particular, he argued that if a money wage reduction occurred,
it was likely to lead to lower prices because marginal costs would be lower (ignoring shifts in productivity due
to issues relating to workforce morale).
Imagine that money wages fell by 5 per cent and the price level fell by 5 per cent, then the real wage would be
unchanged. This was the basis of Keynes’ argument.
He wrote that the idea that money wage cuts would lead to real wage cuts was:
… far from being consistent with the general tenor of the classical theory, which has taught us to
believe that prices are governed by marginal prime cost in terms of money and that money-wages
largely govern marginal prime cost. Thus if money-wages change, one would have expected the
classical school to argue that prices would change in almost the same proportion, leaving the real
wage and the level of unemployment practically the same as before, any small gain or loss to
labour being at the expense or profit of other elements of marginal cost which have been left
unaltered.
18 JAN BLOG
Keynes’ fundamental objection of Classical employment theory thus was that even if workers agreed to work
for lower money wages this did not necessarily guarantee a real wage cut.
Before we consider what this means in terms of Keynes’ own construction of the labour market, we should note
that by accepting the marginal productivity rule (the first Classical postulate) in the General Theory, Keynes was
agreeing with the proposition that for employment to rise the real wage had to fall. As we will see, the causation
that Keynes invoked to explain that association between employment and the real wage was different to the
Classical theory. But in the General Theory, Keynes considered that the firms were always “on” their demand
curve and aggregate demand fluctuations shifted employment up and down that curve.
As a result, he argued that the best way to engineer reductions in the real wage was not to try to tinker with
money wages (for all the reasons we have just considered) but rather to generate some inflation by stimulating
aggregate demand. He thought that as demand for goods and services rose, firms would expand production and
encounter increased marginal costs and so push up the profit-maximising price level.
As a consequence with a rigid money wage, even though the real wage would fall, unemployed workers would
be prepared to supply more labour to the firms. The unemployment was thus driven by the lack of demand
rather than an excessive real wage but the real wage would fall as employment rose. We will return to this
argument in the next Section.
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The fact that both major theories – Classical and Keynesian – at this stage agreed that there would be an inverse
relationship between employment and the real wage makes it difficult to empirically examine the veracity of
either even though the underlying causality that creates the relationship is very different. If we observed a fall in
real wages accompanying a rise in employment which theory would be correct?
However, as an historical note, by 1939, Keynes had changed his view about marginal productivity. Two
separate studies persuaded him that his earlier views on marginal productivity theory were unsupportable by the
evidence. One was published in 1939 by the American economist – John Dunlop – The Movement of Real and
Money Wage Rates – The Economic Journal, Vol. 48, No. 191 (September, 1938), 413-434) and the other, a
year later, by Canadian economist – Lorie Tarshis – Changes in Real and Money Wages – (The Economic
Journal, Vol. 49, No. 193 (March, 1939), 150-154).
What these articles demonstrated was that there was no definitive inverse relationship between real wages and
employment, which meant that the idea that a reduction in unemployment could be accomplished by driving up
the general price level to deflate a fixed money wage was unsustainable.
Interestingly, Keynes responded these articles in his own 1939 Economic Journal article – Relative Movements
of Real Wages and Output – (The Economic Journal, Vol. 49, No. 193 (March, 1939), 34-51). He said (page 34)
that the research presented:
… clearly indicate that a common belief to which I acceded in my “General Theory of
Employment” … needs to be reconsidered …
He also agreed (Page 40) it was likely that “the falling tendency of real wages in periods of rising demand” is
contrary to the real world evidence and suggested that made the argument about effective demand being the
crucial determinant of employment rather than real wages more easy to make.
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11.14 Understanding Labour Supply
We are now in a better position to understand the meaning of the rather difficult definition of involuntary
unemployment that Keynes presented in the General Theory (1936, Page 15) which we introduced in Section
11.4:
Men 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.
In more straightforward language this means that involuntary unemployment exists at the current money wage
level, if employment increased at the same time the general price level rose. This means that workers would
increase their supply of labour even though the real wage was lower than before.
You will appreciate from our discussion in the previous Section that this definition was predicated on his view
that real wages would be lower at higher levels of employment, a view he subsequently abandoned. The
definition is, however, helpful in summarising the point that the money wage level is not the problem when we
are trying to understand unemployment.
It also focused Keynes’ attention on the second postulate of Classical theory relating to the claim that
macroeconomic labour supply was an increasing function of the real wage and the equilibrium employment
level was determined by the equality of labour demand and labour supply.
If workers supplied more labour even though real wages had declined, then this observation seriously
compromised these two Classical claims and largely negated their theory of employment.
However, in the strategic context of his debate with the Classics, Keynes’ definition maintained the focus on the
labour market, which allowed his essential insight that a credible theory of employment should be based on the
principle of effective demand (that is, the product market) to be somewhat obscured.
We can develop a more general definition of involuntary unemployment, which is consistent with Keynes’ later
recognition that real wages do not have to fall for employment to rise, and consistent with what we observe in
the real world. It is also consistent with Keynes’ second definition of involuntary unemployment which he
outlined in Chapter 3 of the General Theory (1936, Page 28).
Accordingly, we might conclude that involuntary unemployment exists:
If when effective demand rises in the product market employment rises independent of what is
happening to money or real wages.
You will appreciate that this definition of involuntary unemployment takes the focus of the concept away from
the labour market and allows us to understand that employment is driven by shifts in aggregate demand.
Further, if aggregate demand rises and there are no further increases in employment observed, then the economy
would be at full employment. Once again this allows us to define full employment in terms of a number of jobs
rather than in terms of some particular real wage. Unlike the Classical Theory of Employment, which considers
full employment to be determined in the labour market, our definition here clearly relates the concept of full
employment to spending developments in the goods and services market.
To better understand this concept, consider how we might reconsider the macroeconomic labour market. In
particular, the labour supply function that is consistent with this concept of involuntary unemployment is quite
different to that presented in the Classical model. Instead of being an increasing function of the real wage, based
on the assertion that workers face a trade-off between labour and leisure, which is mediated by movements in
the real wage, Keynes’ considered workers supplied their labour based on the current money wage level and
faced considerable uncertainty about the price level.
In other words, workers knew what the money wage they were receiving because it was this variable that was
determined in the labour market rather than the real wage. The real wage equivalent of the known money wage
was uncertain because the price level was not set in the labour market and workers had imperfect information
about the current price level.
The relevant labour supply function is thus written as:
(11.10)
Ns = f(W,Pe) if Ns < N*
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Which says that aggregate labour supply (Ns) depends on the money wage level (W) and the expected price
level (Pe) up to full employment (N*)
Figure 11.8 shows the Keynesian labour supply function. The first important difference when compared to the
Classical labour market depicted in Figure 11.3 is that the money wage is determined in the labour market rather
than the real wage. Workers prefer higher real wages to lower real wages, but when they enter the labour market
it is the money wage they agree on with the employer not the real wage.
Full employment occurs at N* and beyond that level we might assume that there would be no further increases in
labour supply. In the real world, it is likely that rising money wages at the current price level might attract extra
workers in to the labour market who would not usually wish to work. In other words, the vertical segment in the
labour supply might be slightly positively sloped.
Up to N*, at the current money wage level (W1), workers will be willing to supply whatever labour is demanded.
The vertical lines – ED1 and ED2 – reflect macroeconomic demand for labour curves that are driven by the
current level of effective demand which is determined in the goods and services market (that is, outside of the
labour market). The ED lines can be thought of as constraints imposed on the labour market, with employment
adjusting at the current money wage levels to shifts in these constraints.
Assume that the economy is operating at an effective demand level, ED 1 and employment is at N1. How much
involuntary unemployment is there at that level of economic activity?
The answer is the distance N* – N1, because if effective demand was at ED*, the labour supply would increase to
N*. To see that more clearly imagine that aggregate demand increased and the economy moved to a higher level
of effective demand, ED2. With no change in the money wage rate (or the price level), employment would
increase to N2 and unemployment would fall by N2 – N1.
This reasoning allows you to understand that the macroeconomic level of unemployment is not exclusively
determined in the labour market and variations in unemployment are driven by variations in effective demand.
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Figure 11.8
Keynesian Aggregate Labour Supply Function
ED1
ED2
ED*
W
NS (Pe)
W1
N1
N2
N*
Employment
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Blog 24 Jan 13
11.15 Keynes Rejection of Say’s Law – The Possibility of General
Overproduction
Refresher – The Loanable Funds Market
The Classical theory of interest underpins Say’s Law and the claim by Classical economists that there could not
be a situation where aggregate demand was insufficient to absorb all production. The contention was that when
firms choose to supply goods and services they produce output and income. That income has to be either
consumed or saved.
In the Classical theory, the interest rate ensures that the income that is not consumed in each period (that is,
which is saved) is also equal to aggregate investment (the creation of new productive capacity). This is the
loanable funds doctrine, which we considered in Section 11.8.
Recall that the demand for loans (from firms seeking to invest in new productive capacity) was considered a
decreasing function of the interest rate, the latter being the cost of borrowed funds, which would determine
which investment projects were marginal and which were profitable (given expected revenue flows arising from
the investment).
On the other side of the loanable funds market, saving was considered to be an increasing function of the
interest rate because at higher interest rates the return on the foregone consumption (saving) would be higher
and ensure higher future consumption than at lower interest rates.
The interest rate was conceived as the price of current consumption relative to future consumption. In other
words, a consumer could use their income now for consumption, which necessarily meant they couldn’t use it in
the future. The opportunity cost of making that decision was measured by the premium they could expect by not
consuming now and loaning that income at the current interest rate. The higher the interest rate (the premium)
the cheaper future consumption became relative to current consumption.
The loanable funds doctrine thus conjectured that if consumers decided to save more out of their disposable
income than before, the supply of loans into the loanable funds market would increase, creating an excess
supply at the current market interest rate, and market forces would start driving the interest rate down.
The falling interest rate would stimulate investment (demand for loans) and the combination of declining
intention to save (as interest rates fell) and rising demand would eventually restore equilibrium in the loanable
funds market (saving equals investment) at a lower interest rate.
In other words, the lost consumption spending would be replaced by increased investment spending. Real world
factors like how do workers and firms easily and instantaneously shift between the production of consumption
goods to the production of investment (capital) goods were assumed away.
As we will see, there is also a major issue of what market signal is provided by a decline in consumption. The
implication is that the rising saving signals a desire to consume more in the future and firms re-assemble their
production of capital goods to meet that demand in the future. But what consumption goods will be demanded in
the future and when? These are major stumbling blocks for the Classical economists and were, in part, at the
centre of Keynes’ attack on the Classical theory.
The hypothesised movements in interest rates thus ensured that there could never be an enduring excess demand
or supply of loans, which then meant that aggregate demand for goods and services would always adjust to
movements in aggregate supply. So full employment was ensured by the combination of real wage clearing any
imbalances between the demand for and the supply of labour and the interest rate moving to ensure the
composition of final output supplied (between current and future goods) was always consistent with the
aggregate spending (consumption and investment).
Keynes’ Critique of the Loanable Funds Doctrine
Keynes was writing as he was observing what was happening in the real world during the Great Depression. It
was clear that investment had fallen as had national income as economies plunged into economic crisis with
rising unemployment. The flow of saving also fell in proportion with the decline in national income. While all
these variables seemed related in ways that we now understand they were largely disconnected from movements
in interest rates and the key predictions of loanable funds theory appeared to be without foundation.
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Keynes thus considered the Classical belief that the household decision to save was determined by the
preferences for current and future consumption mediated by the interest rate (the price that consumers traded
current consumption for future consumption). Instead, he considered aggregate saving was a positive function of
national income.
So when national output and income rise, aggregate saving will rise. The amount of extra saving per dollar of
additional disposable income is called the Marginal Propensity to Save (MPC). If the MPC = 0.20, then
households will save 20 cents of every extra dollar of disposable income they receive.
The interest rate might have some influence on saving but Keynes considered the influence of changes in
national income to the dominant factor determining the aggregate level of savings in any period.
The other consideration is that investment spending is a component of aggregate demand, which in turn, drives
total national income in each period.
Taken together, these insights undermine the concept of a loanable funds market in the way conceived by the
Classical economists. There could not be independent saving and investment functions brought together by
movements in the interest rate as required by the loanable funds doctrine because investment drove income
which influenced saving.
In Chapter 14 The Classical Theory of the Rate of Interest – of his General Theory of Employment, Interest and
Money, Keynes (yr: 180) produced a diagram to illustrate his contention that this interdependency meant the
loanable funds doctrine was a “nonsense theory”.
Keynes wrote:
The independent variables of the classical theory of the rate of interest are the demand curve for
capital and the influence of the rate of interest on the amount saved out of a given income; and
when (e.g.) the demand curve for capital shifts, the new rate of interest, according to this theory, is
given by the point of intersection between the new demand curve for capital and the curve relating
the rate of interest to the amounts which will be saved out of the given income. The classical
theory of the rate of interest seems to suppose that, if the demand curve for capital shifts or if the
curve relating the rate of interest to the amounts saved out of a given income shifts or if both these
curves shift, the new rate of interest will be given by the point of intersection of the new positions
of the two curves. But this is a nonsense theory. For the assumption that income is constant is
inconsistent with the assumption that these two curves can shift independently of one another. If
either of them shift, then, in general, income will change; with the result that the whole
schematism based on the assumption of a given income breaks down … In truth, the classical
theory has not been alive to the relevance of changes in the level of income or to the possibility of
the level of income being actually a function of the rate of the investment.
Keynes’ diagram had investment and saving on the vertical axis and the interest rate on the horizontal axis. To
maintain continuity with Figure 11.7, we reproduce his graph but reverse the axis.
Relating Keynes lengthy argument (in the last quote) to Figure 11.9is straightforward. The family of saving
functions, S(Y0), S(Y1), and S(Y2) – are drawn for different levels of income (with Y2 > Y0). For each saving
function, say S(Y0), the curve shows the level of saving at the level of income for each interest rate level.
The family of investment functions, I(Y0), I(Y1), and I(Y2) – show that when investment is higher, national
income rises.
The loanable funds equilibrium, say at Y0 would be at the intersection of S(Y0) and I(Y0), generating an interest
rate of R0.
Loanable funds theory, however, did not allow for changes in national income to impact on saving in this way.
Accordingly, imagine investment moves from I(Y 0) to I(Y1). We know that the shift in investment will drive up
national income because investment is a component of aggregate demand. The loanable funds doctrine would
argue that the shifting investment function would move along the saving function (S( 0) and the interest rate
would increase to RLF.
The rise in the interest rate would be necessary, according to loanable funds theory, to eliminate the excess
demand for funds at R0 arising from the rise in investment.
Keynes argued that if saving is a function of national income then the Classical approach fails to describe the
adjustment in interest rates. He said (Yr: 180) that:
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…the above diagram does not contain enough data to tell us what its new value will be; and,
therefore, not knowing which is the appropriate … [saving function] … we do not know at what
point the new investment demand-schedule will cut it.
We have specified that S(Y1) is the appropriate saving relationship at national income Y1, which coincides with
the increase in output associated with the boost in investment spending. But that insight is missing in the
loanable funds doctrine.
In other words, the loanable funds doctrine could not explain movements in interest rates and a new theory was
required. It was at this point that Keynes proposed the concept of liquidity preference as the foundation of his
theory of interest rates.
Figure 11.9
The Interdependence of Saving and Investment
S(Y2)
Interest Rate
S(Y1)
S(Y0)
RLF
I(Y2)
R0
I(Y1)
I(Y0)
Quantity of Funds
To recapitulate, Keynes found that once we realise that investment and saving functions will shift when national
income changes, the theory of interest provided by the loanable funds doctrine failed because it provided no way
of knowing how far the investment and saving functions might shift with changes in national income.
This is because the Classical theory considered the level of national income to be constant at the full
employment level. Their employment theory was based on their abiding faith that real wage movements would
ensure the demand for and supply of labour were in balance and full employment constantly generated.
It was obvious that national income and employment were not constant and certainly during the Great
Depression, the mass unemployment demonstrated that enduring departures from full employment were a basic
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feature of the monetary system. With investment and saving also moving with shifts in national income, Keynes
concluded that a theory of interest rates had to be found elsewhere.
Liquidity Preference and Keynes’ Theory of Interest
Liquidity preference was a concept introduced by Keynes to provide the basis for an alternative theory of
interest to that found in the loanable funds doctrine. He considered that a theory of interest had to be ground in
an understanding of the way in which money and financial markets operate – in particular, the way in which
people and firms adjust their wealth portfolios of money and bonds.
Recall that the Classical Theory of Interest considered the interest rate to be a real rather than a monetary
variable. Savers were paid interest as a reward for abstemious behaviour – foregoing the consumption of real
goods and services now and allowing these resources to be invested in order to build productive potential.
How can borrowers afford to pay interest? For the Classical economists the answer was easy. By using the
savings of households, firms could become more productive in the future through the accumulation of capital
and the interest paid came from the extra real goods and services that the economy could produce.
So savers enjoyed a premium in terms of higher future consumption of real goods and services made possible by
the increased investment that the borrowing allowed. Saving was a real act – the foregoing of consumption of
real goods and services now – as was investment – the construction of capital leading to increased goods and
services in the future.
For Keynes, the interest rate was a monetary rather than a real variable, which was an important input into a
plethora of financial decisions that people made in determining the form of their wealth portfolios.
In contrast to the loanable funds doctrine, which believed the rate of interest determined the flow of saving and
investment in the economy, Keynes believed that the level of effective demand determined saving via the
propensity to consume. Once aggregate demand is known, then the level of consumption was determined by the
resulting national income level.
In – Chapter 13 The General Theory of the Rate of Interest – of his General Theory of Employment, Interest and
Money, Keynes said that the “propensity to consume … determines for each individual how much of his income
he will consume and how much he will reserve in some form of command over future consumption” (PAGE
REFERENCE).
The “command for future consumption” is what we call saving and is a residual from the act of consumption,
which is largely driven by movements in national income (and taxation). The interest rate does not determine
this flow.
So what impact does the interest rate have?
Keynes then noted (PAGE REFERENCE):
But this decision having been made, there is a further decision which awaits him, namely, in what
form he will hold the command over future consumption which he has reserved, whether out of
his current income or from previous savings. Does he want to hold it in the form of immediate,
liquid command (i.e. in money or its equivalent)? Or is he prepared to part with immediate
command for a specified or indefinite period, leaving it to future market conditions to determine
on what terms he can, if necessary, convert deferred command over specific goods into immediate
command over goods in general? In other words, what is the degree of his liquidity-preference —
where an individual’s liquidity-preference is given by a schedule of the amounts of his resources,
valued in terms of money or of wage-units, which he will wish to retain in the form of money in
different sets of circumstances?
Instead of interest being a payment for “waiting” as in the loanable funds doctrine, Keynes considered it to be a
payment a person received for shifting their wealth from liquid money holdings (cash) to some less-liquid
financial asset.
The concept of liquidity preference was introduced by Keynes to explain how people made the choice
concerning the composition of their wealth. Holding wealth in its most liquid form (money) had advantages – it
was risk free – but it also earned no interest and inflation could deflate its value.
The alternative would be to hold some or all of one’s wealth in, say, bonds, which attracted an interest premium.
What might motivate a person to invest in bonds, which were less liquid and carried risk that their capital value
could fall with adverse market movements (an excess supply)?
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The interest rate was the reward for the inconvenience of storing one’s wealth in a less-liquid form and the risk
of capital loss.
The important point is that for Keynes, the rate of interest did not determine aggregate savings but influenced
the way that any savings were prorated between liquid and less-liquid financial assets.
The interest rate also ensured that the demand for liquidity (money holdings) was equal to the supply of money.
We will return to this issue in Chapter 14 when we discuss money and banking.
As we will see in Chapter 12, the rate of interest also influences the level of national income because it is one of
the variables that influences the decision by firms to invest in productive capacity.
The important point of Keynes’ attack on the Classical theory of interest was that it debunked Say’s Law, which
meant that there was no automatic, market mechanism in a capitalist monetary economy that would ensure that
all goods and services supplied would be consistent with aggregate demand.
It was then understandable that such economies could over-produce goods and services as a result of the
aggregate demand expected by business firms was overly optimistic. As a result, firms would have unsold
inventories and their adjustments to the lower realised aggregate spending would lead to output, income and
employment cuts.
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11.16 The Macroeconomic Demand for Labour Curve
Blog 25 Jan 13
The Interdependency of Aggregate Supply and Demand
While Keynes’ critique of Classical employment theory was focused mostly on showing that the Classical
labour supply construction was deeply flawed, his ideas on the impact of money wage changes on effective
demand allows us to derive a consistent aggregate demand curve for labour, which replaces the marginal
productivity theory and shows how effective demand determines employment.
Recall that the Classical employment theory considered unemployment (beyond frictional levels) to be the result
of the real wage being higher than the equilibrium level, which was tied to a unique level of productivity that
would occur if labour demand was equal to labour supply.
The major result from that theory is that flexibility of money wages (and hence real wages) will continuously
clear the labour market and maintain full employment.
In this approach, given that profit-maximising firms are assumed to be constrained by diminishing marginal
productivity of labour, they will only employ more workers if the real wage falls because each additional worker
hired is less productive than the last and profit maximisation requires that the real wage (the output cost of the
additional unit of labour) be equated with the marginal product (the contribution to output of the last unit of
labour).
If we think about this in terms of the production of real goods and services, each additional unit of labour adds
to production but is assumed to add less than the previous unit(s) employed. When money wages fall the
marginal cost of production falls (assuming productivity is constant) and the firm’s output supply curve shifts
out – that is, they are prepared to supply more at each price level because their unit costs are lower.
The Classical theory considered the aggregate supply curve (relating the prices that are sought at each supply
level) to be the sum of the industry supply curves, which, in turn, were considered to be aggregates of the firm
supply curves. As a result, when money wages fell the supply curves of firms, the industry and all industries
shift outwards.
In – Chapter Changes in Money Wages – of his , Keynes wrote (page 259 CHECK):
The argument simply is that a reduction in money-wages will cet. par. stimulate demand by
diminishing the price of the finished product, and will therefore increase output and employment
up to the point where the reduction which labour has agreed to accept in its money-wages is just
offset by the diminishing marginal efficiency of labour as output (from a given equipment) is
increased.
Keynes realised that this reasoning was flawed at the most elemental level. For it assumes that the aggregate
supply curve (the sum of all the firm supply curves) shifts out as money wages fall and traces out a path along a
fixed aggregate demand curve. That is, output increases.
Keynes said (page 259):
In its crudest form, this is tantamount to assuming that the reduction in money-wages will leave
demand unaffected.
In other words, the Classical theory assumed that the aggregate supply and aggregate demand curves were
independent of each other and when the aggregate supply curve shifted out the aggregate demand curve was
unchanged.
Hence, the money wage cut leads to an expansion of output because firms are prepared to hire more workers and
to supply more output at the given price level.
Keynes wrote (page 259) that:
… whilst no one would wish to deny the proposition that a reduction in money-wages
accompanied by the same aggregate effective demand as before will be associated with an
increase in employment, the precise question at issue is whether the reduction in money-wages
will or will not be accompanied by the same aggregate effective demand as before.
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Once again this is an example where specific to general reasoning provides the wrong answer. What might
apply at the single firm or even industry level does not necessarily apply at the aggregate level. That is the basis
of the fallacy of composition, which we explained in the context of the Paradox of Thrift in Chapter 7.
At the specific or individual firm level, the firm’s output supply curve might shift out (meaning it will be
prepared to supply more output at each price level) after it cuts the money wage of its workers. The firm could
expect no shift in the demand for its product as a result of the money wage cut. The lower wages now paid to the
firm’s workers will lower its unit costs (and push its supply out) but would not be significant enough, in the
economy-wide context, to influence the demand for the firm’s output.
Keynes was prepared to accept that logic (page 259):
It is indeed not unlikely that the individual entrepreneur, seeing his own costs reduced, will
overlook at the outset the repercussions on the demand for his product and will act on the
assumption that he will be able to sell at a profit a larger output than before.
But what if all firm’s cut money wages? The Classical theory of employment focused on only one aspect of
money wages – that they were a cost of production and influenced the supply-side of the economy. However,
Keynes noted that money wages were also a significant component of a worker’s income and by aggregation,
national income.
Given that consumption spending was directly tied to national income and investment spending was also likely
to fall, if consumption spending fell, Keynes argued that the demand curves (at the firm, industry and aggregate)
level would shift inwards (spending at each price level would be lower) after a money wage cut.
While firms might enjoy lower unit costs they also faced a declining demand for their goods, in general, because
the lost income resulting from an economy-wide money wage cut would be significant.
This insight means that the output demand and supply curves are interdependent. A shift in the supply curve out
resulting from a money-wage cut will also manifest as a shift in the demand curve inwards. This
interdependency also negates the Classical construction of the aggregate marginal productivity curve being the
macroeconomic demand curve for labour.
In the Classical employment theory, a money wage cut (indicating that the labour supply curve has shifted out
because workers in aggregate will not supply more hours of work at each money wage level) leads to a
movement along a fixed marginal productivity curve. However, once we recognise the interdependency
between the demand and supply sides, it is clear that the marginal product curve loses its capacity to describe
what will happen to employment.
The overall impact on employment of a money wage cut (or rise) will depend on the relative magnitudes of the
supply and demand shifts.
In the case of a money wage cut, for example, if the aggregate supply curve shifts out and the aggregate demand
curve shifts in, then it is possible that employment rises, does not change or declines. The marginal productivity
demand curve for labour only permits the first option and therefore cannot be a general macroeconomic demand
curve for labour.
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Blog 31st Jan 13
MATERIAL HERE FROM LAST WEEK … THE FOLLOWING SECTION IS WHERE I REACHED LAST TIME
AND IS SLIGHTLY RE-WRITTEN TO BETTER DEVELOP THE ARGUMENT.
Money Wage Changes and Shifts in Effective Demand
The clue to deriving a macroeconomic labour demand curve is to analyse the impact of money wage changes on
effective demand, which means we consider the relative magnitudes of the shifts in aggregate supply and
aggregate demand, as outlined in Chapters 5, 6 and 7.
Recall from Chapter 7, we noted that the point of nominal effective demand is found at the intersection of the
aggregate demand (D) and aggregate supply price (Z) curves. We learned that the point of effective demand
occurs where all individual firms are maximising expected profits.
Keynes defined the aggregate supply price of the output derived for a given amount employment as the
“expectation of proceeds which will just make it worth the while of the entrepreneur to give that employment”
(footnote to Keynes, J.M. (1936) The General Theory of Employment, Interest and Money, Macmillan, page 24
– check page).
We learned that this concept related a volume of revenue received from the sale of goods and services to each
possible level of employment. At each point on the aggregate supply price curve, the revenue received would be
sufficient to cover all production costs and desired profits at the relevant employment level.
The other way of thinking about the aggregate supply price Z-function is to express it as the total amount of
employment that all the firms would offer for each expected receipt of sales revenue from the production that
the employment would generate.
Firms build a stock of productive capital through investment in order to produce goods and services to satisfy
demand. Once the capital stock is in place, firms will respond to increases in spending for the goods and
services they supply by increasing output up to the productive limits of their capital and the available labour and
other inputs. Beyond full capacity, they can only increase prices when increased spending occurs.
Aggregate demand is the total purchases by households, firms, government and foreigners (rest of the world) on
goods and services produced by domestic and foreign firms. The volume of real output supplied to the economy
is determined by aggregate demand subject to there being idle productive capacity.
NEW TEXT STARTS TODAY HERE
The Z-function in Figure 11.9 is drawn under the assumption that:

The stock of capital equipment is constant.

The money wage level is fixed.

The productivity of labour is fixed.
A change in any of these variables would shift the function (refresh the discussion in Chapter 7 if you have
forgotten how the Z-function shifts).
The other characteristic of the Z-function is that each point on Z (a given expected sales revenue) represents a
particular level of income. Thus we consider at each income level, firms will estimate expected sale revenue and
costs required to generate the production to meet those sales, which, in turn, defines the level of aggregate
employment.
So moving up a given Z-function means the firms will be producing more output and employ more workers as
income rises.
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Figure 11.10
Aggregate Demand (D) and Aggregate Supply or Proceeds (Z)
Expected
Sales
Revenue;
Planned
Expenditure
Z(W0)
D(W0)
E0
Employment
The D-function describes how much demand there will be in the economy at different (implied) income levels.
We also assume that the money wage is fixed along any given D-function. Thus as employment rises, total
national income rises and spending rises accordingly.
The intersection of the D- and Z-functions define the point of effective demand. In Figure 11.10 the D- and Zfunctions are drawn for a given money wage level, W 0, as denoted in the parenthesis.
Any point to the left of the intersection define situations where aggregate demand exceeds aggregate supply and
firms would be motivated to expand production (after revising their expected sales revenue upwards in the light
of inventory depletion). As a consequence, employment and income will rise until aggregate demand and
aggregate supply are equal again.
Any point to the right of E0, defines a situation where aggregate supply exceeds aggregate demand and the
inventory cycle will see firms reduce output, employment and income as they revise their expectations of future
sales revenue downwards.
Macroeconomic equilibrium thus occurs for the current given money wage rate at E 0, which determines total
employment in the economy.
From our earlier discussion, the money wage impacts on both the supply and demand sides of economy. A
change in the money wage changes the marginal costs at the firm level, which, in turn, impacts on the industry
supply curve and thus shifts the aggregate Z-function.
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At each employment level, a rise in the money wage will push the Z-function up because the firm now requires
more sales revenue to sustain the same employment and output levels to satisfy their profit expectations.
But, the higher money wages also means that at each employment level, incomes paid out are higher and this
stimulates aggregate demand (in the first instance via higher aggregate consumption), As a consequence, the Dfunction shifts up when the money wage rises (and shifts down in money wages are cut).
The intersection between aggregate demand (D) and aggregate supply (Z), which defines the point of effective
demand, will thus be sensitive to changes in the money wage, and depends on the magnitude of the money
wage. This, in turn, sets the level of employment that firms will offer and the level of output and national
income generated by the economy.
We can draw a family of aggregate D- and Z-functions (and points of effective demand) corresponding to
different money wage levels. This, in turn, allows us to relate each money-wage level with a particular point of
effective demand and aggregate employment.
Which means each point of effective demand and money wage combination constitutes a point on the
macroeconomic labour demand function. The importance of the recognition is that the Classical theory of
employment considered the marginal productivity function to define the macroeconomic labour demand
function without reference to the goods and services market.
The approach adopted by Keynes and those who subsequently followed him, situated the derivation of the
macroeconomic labour demand function in the labour market in the goods and services market – by examining
how money wage movements influence the point of effective demand.
In Figure 11.11, the point E0 is thus one point on the macroeconomic labour demand function corresponding to
money wage level, W0.
How we draw the family of aggregate D- and Z-functions (and resulting points of effective demand) for each
money wage level depends on how changes in the money wage impacts on each function.
What happens to total employment when the money wage changes depends on how far the D- and Z- functions
shift in response to the changing money wage. Three different situations can be defined:

A money wage change shifts the D-function by less than the Z-function and thus employment
falls when the money wage rises and rises when the money wage falls.

A money wage change results in equivalent shift in the D- and Z-functions and employment
does not change.

A money wage change shifts the D-function by more than the Z-function and thus
employment rises when the money wage rises and falls when the money wage falls.
In his famous 1956 article – A Macroeconomic Approach to the Theory of Wages – American economist Sidney
Weintraub discussed the likely relationship between money wage changes and aggregate employment.
Weintraub (1956) said the first situation defined above was consistent with the traditional notion that when
wages rise, employment falls. He called this the “classical”, which reflects the notion in Classical employment
theory that unemployment can be eliminated by cutting money wages.
The “classical” case is shown in Figure 11.11. The upper graph shows the family of D- and Z-functions for
different money wage levels, W0, W1, and W2, with W0 < W2.
The Z-function shifts upwards as the money wage rate rises by more than the D-function. The green, ED line
joins the intersections of each of the points of effective demand that are established at each money wage level.
These points of effective demand, in turn, determine a given employment level for each money wage level.
The lower panel in Figure 11.11 depicts the labour market, with the money wage on the vertical axis and
employment on the horizontal axis. The horizontal scales on the upper and lower panels are equivalent and
measure total employment.
We can thus trace the points of effective demand (where aggregate demand, D- is equal to aggregate supply, Z-)
corresponding the different money wage rates from the upper panel to the lower panel and thereby derive the
macroeconomic demand for labour curve, which shows the relationship between money wages and
employment.
Thus, we can derive the macroeconomic demand for labour curve by deriving all points of effective demand for
all money wage levels. The lower panel thus shows that if the Z-function shifts by more than the D-function as a
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result of a money wage change, the resulting macroeconomic demand for labour curve will be negatively
sloped.
This is what Weintraub called the “classical” case.
Figure 11.11
The Classical Case
Z(W2)
Expected
Sales
Revenue;
Planned
Expenditure
ED
Z(W1)
D(W2)
D(W1)
Z(W0)
D(W0)?
ED
E2
E1
E0
Employment
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Money
Wage
Rate
W
E2
E1
E0
W2
W1
W0
Macroeconomic
Demand Curve
for Labour
E2
E1
E0
Employment
As we have seen in this discussion, Keynes attacked the Classical employment theory because he did not believe
that employment was particularly sensitive to money wage movements. In terms of the three possibilities for the
relative movements in the D- and Z-functions noted above, Keynes’ position corresponds to the second option –
the two functions shift more or less equivalently.
Figure 11.12 captures this case, which Weintraub characterised as the “Keynesian case”. You will see that under
these assumptions, the macroeconomic demand curve for labour is vertical and invariant to movements in
money wages.
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Figure 11.12
The Keynesian Case
Z(W2)
ED
Expected
Sales
Revenue;
Planned
Expenditure
Z(W1)
D(W2)
D(W1)
Z(W0)
D(W0)?
E0
E2
E3
Employment
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Money
Wage
Rate
W
E0
E2
E3
W2
W1
W0
Macroeconomic
Demand Curve
for Labour
E0
E2
E3
Employment
The third option – that the D-function shifts by more than the Z-function when the money wage changes, was
referred to by Weintraub as the “underconsumptionist” case. The terminology was derived from a view held by
some economists that money wage changes would influence consumption spending more than anything else.
They believed that rising money wages would stimulate employment because the rise in consumption would
push out the point of effective demand. Figure 11.13 depicts the underconsumptionist case.
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Figure 11.13
The Underconsumptionist Case
ED
Expected
Sales
Revenue;
Planned
Expenditure
Z(W2)
D(W2)
Z(W1)
D(W1)
Z(W0)
D(W0)
E0
E1
E2
Employment
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Money
Wage
Rate
W
E0
E1
E2
W2
W1
W0
Macroeconomic
Demand Curve
for Labour
E0
E1
E2
Employment
Weintraub (1956: 842) said in relation to these three cases that:
… from the standpoint of economic policy their implications are vastly different.
In other words, if, for example, the real world was more like the Keynesian or the Underconsumptionist cases,
then trying to cure unemployment by cutting money wages would fail and, in the Underconsumptionist case,
would be a disaster for employment.
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Posted on Friday, February 1, 2013 by bill
Figure 11.14 depicts a generalised macroeconomic demand curve for labour and you can identify three
distinctive segments. The blue arrow signifies that employment is a function of effective demand, which is
determined outside of the labour market.
Focusing on the solid red line, the interpretation is that when money wages rise above W 2, further rises in the
money wage reduce employment – which is the “classical case” identified above. This would arise because
aggregate supply (Z) was shifting upwards faster than aggregate demand (D).
How might we explain that? At higher money wages (which might be associated with a higher price level),
fiscal and monetary policy might be tightened to head-off an inflationary spiral. The resulting negative impact
on aggregate demand is likely to reduce the point of effective demand below the previous level at W 2.
Further, in an open economy, very high wages might reduce international competitiveness and impinge on
export demand, which will also have a negative impact on aggregate demand and shift the point of effective
demand to the left of its current position.
Both of these impacts would imply that the macroeconomic demand for labour curve takes a classical shape at
high money wage levels. It is highly probable that such a segment would be beyond the range defined by normal
wage movements and levels.
Thus, the negatively sloping upper segment is a logical possibility which would be rarely encountered.
Figure 11.14
A Generalised Macroeconomic Demand Curve for Labour
Money
Wage
Rate
W
W2
Normal Range
W0
Employment
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When money wages are below W0, it is possible that a particular phenomenon which has been named the
“Pigou effect” after the British economist Arthur Pigou. This effect is also referred to more generally as the real
balance effect or the wealth effect.
When Keynes attacked the Classical employment theory he noted that cutting money wages would not likely
lead to a fall in real wages because competition would also drive prices down, given that firms now enjoyed
lower unit costs, assuming productivity did not fall due to low morale brought about by the money wage
decline.
Reluctantly, the Classical economists in the 1930s, which had recommended money wage cuts as the way to
engineer the real wage cuts they considered necessary to restore labour market equilibrium, as per the Classical
model of the labour market, were forced to acknowledge that if money wages were cut and prices followed the
cost reductions, then the real wage might not fall at all. It was possible the real wage could even rise if the fall in
money wages was less than the fall in prices.
However, Arthur Pigou responded in a famous 1943 article with a proposed solution to the problem of the
economy being stuck in an unemployment impasse. He argued that real consumption spending was also a
positive function of the stock of real wealth that individuals possessed. This wealth was held (in nominal terms)
in the form of money balances and other financial assets such as government bonds.
Thus, even if a fall in money wages leads to a equivalent percentage fall in the price level, leaving the real wage
unchanged, the lower prices would increase the real wealth of all those who were holding nominal wealth
balances. So all wealth holders would feel richer as a consequence and it was argued would thus increase real
consumption at each level of income.
The increase in real balances at lower prices thus gave proponents of the Classical employment theory another
conduit through which money wage falls could stimulate employment, in the event that real wages did not
move.
In other words, the inverse relationship between money wages and employment was restored by this real
balance effect.
It was pointed out that borrowers would feel poorer when prices fell, because the real value of their debt burdens
would rise and, using the same logic, this would lead to a reduction in real consumption at each level of income.
To some extent this would offset the stimulus that the debt holders might impart.
If most of the debt was in the form of government bonds, then the net effect would probably be larger than if
private lenders had provided the majority of the debt held.
Thus, when money wages are very low, Weintraub (1956?: page??) wrote that:
… those owning “pennies” become “millionaires” – a calamitous prospect! – full employment
may well be assured.
In the real world, if prices fell so low that a real balance effect of any significant size was generated, then it is
likely that the entire banking system would collapse because while the nominal liabilities held by the banks
would not be altered, their real values would rise by so much as to bankrupt most of their borrowers. The mass
defaults would, in turn, cripple the financial system.
The empirical evidence is that in normal price movement ranges, the measured real balance or wealth effect is
very small and clearly insufficient to remedy a major shortfall in aggregate demand. So while the Pigou effect
presents a logical possibility it did not provide the Classical employment theory with the response it required to
negate the damaging critique made by Keynes.
Money wage rates between W0 and W2 – denoted the normal range in Figure 11.13 – are likely to lead to no
change in the point of effective demand and thus the macroeconomic demand curve for labour will be vertical.
For employment to change there has to be a change in the level of effective demand.
The vertical segment could also be positively sloped if there was evidence of an underconsumptionist response
in the normal range of money wage movements. It is possible, for example, in poorer nations, that the demand
boost from a money wage rate rise will outstrip the supply response arising from the extra unit costs. As a
consequence the slope of the macroeconomic demand curve for labour in this relevant range will be positively
sloped as depicted in Figure 11.12.
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11.17 The Determination of Employment and the Existence of Involuntary
Unemployment
We are now in a position to finish the story having both the demand and supply sides of the labour market
explained. Figure 11.7 showed the Keynesian labour supply function, which was a function of the money wage,
and changing price expectations would lead to shifts in this function. In Figure 11.7 we determined the total
employment level by considering where the vertical macroeconomic demand for labour curves intersects the
given money wage rate.
Section 11.15 has now allowed you to acquire a deeper understanding of how that macroeconomic demand
curve for labour is driven by the current level of effective demand which is determined in the goods and services
market. In other words, you can appreciate that the level of employment in the economy is a function of
effective demand rather that the wage rates in the economy.
You are also now able to appreciate that mass unemployment in the economy is also determined by the state of
effective demand rather than being a caused by the ascriptive characteristics of the unemployed themselves. The
unemployed become powerless to improve their prospect because the shortage of jobs is caused by a systematic
failure of aggregate demand (relative to aggregate supply).
In Figure 11.15, total employment is current at N0 and the money wage rate is at W0. The full employment level
of employment is at NFull. As a consequence, the level of involuntary unemployment at this level of effective
demand is measured by the distance NFull – N0.
The lesson that Keynes taught us, which had been denied by the Classical theory of employment, was that at the
current wage rate, W0, a demand stimulus in the goods and services market, which shifted the macroeconomic
demand curve for labour outwards towards full employment, would not only stimulate employment but, at the
same time, reduce unemployment, without any change in the money wage (or price level) being required.
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Figure 11.15
Employment and Unemployment
Money
Wage
Rate
W
Full Employment
W0
Unemployment
N0
NFULL
Employment
Mass unemployment is always driven by variations in effective demand and the policy indication is
straightforward. For a given level of non-government spending (consumption, investment and net exports), mass
unemployment arises because the budget deficit – that is, the level of net public spending (G – T) is not large
enough. The cure for mass unemployment, in the event of non-government spending being static is to expand
the budget deficit.
This was an important lesson that governments learned in the 1930s and which was placed in a theoretical
framework by the work of Keynes and others. The Classical theory of employment distracted policy makers
from seeing that the fundamental solution to unemployment was to increase aggregate demand relative to
aggregate supply. As a consequence, in the early years of the Great Depression in the 1930s, millions of workers
lost their jobs as governments tried to implement the wage cutting solutions proposed by the dominant Classical
viewpoint.
It was only when governments expanded their deficits that the Great Depression came to an end.
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11.18 A Classical Resurgence Thwarted
One of the key elements of Keynes’ attacks and ultimate discrediting of the Classical employment theory was
his identification of what we call the fallacy of composition.
Prior to the 1930s, there was no separate study called macroeconomics. The dominant theory of the day,
characterised by the Treasury View – considered macroeconomics to be an exercise in the aggregation of
individual relationships.
The economy was thus seen as being just like a household or single firm only bigger. Accordingly, changes in
behaviour or circumstances that might benefit the individual or the firm are automatically claimed to be of
benefit to the economy as a whole.
The general reasoning failure that occurs when one tries to apply logic that might operate at a micro level to the
macro level is called the fallacy of composition. The identification of such fallacies in Classical models led to
the establishment of macroeconomics as a separate discipline in the 1930s, after Keynes published the General
Theory.
The insistence in the Treasury View that wage cuts would cure the mass unemployment that arose during the
1930s Great Depression symbolised the fact that their reasoning was based on compositional fallacies.
Keynes led the attack on the mainstream by exposing several fallacies of composition. While these types of
logical errors pervade mainstream macroeconomic thinking, there are two famous fallacies of composition in
macroeconomics: (a) the paradox of thrift; and (b) the wage cutting solution to unemployment.
The paradox of thrift describes a situation where individual virtue can be public vice. Imagine consumers en
masse try to save more and there is no compensating aggregate demand from other sources to replace the lost
consumption spending. The theory of effective demand, which we have developed in Chapters 7 and 8 as well
as this Chapter, allows us to understand that everyone will suffer in this instance because national income falls
(as production levels react to the lower spending) and unemployment rises.
The paradox of thrift tells us that what applies at a micro level (ability to increase saving if one is disciplined
enough) does not apply at the macro level. Thus, if an individual tried to increase his/her saving (and saving
ratio) they would probably succeed if they were disciplined enough. But if all individuals tried to do this at the
same time, and nothing else replaces the spending loss, then everyone suffers because national income falls (as
production levels react to the lower spending) and unemployment rises. The impact of lost consumption on
aggregate demand (spending) would be such that the economy would plunge into a recession.
As a result, incomes would fall and individuals would be thwarted in their attempts to increase their savings in
total because saving is a function of income. In other words, what works for one (the micro level) will not work
for all (the macro level).
The causality reflects the basic understanding that output and income are functions of aggregate spending
(demand) and adjustments in the latter will drive changes in the former. It is even possible that total savings will
decline in absolute terms when individuals all try to save more because the income adjustments are so harsh.
In our discussion of the macroeconomic demand for labour curve we also saw that the Classical employment
theory was be-devilled by compositional fallacy. Recall, that when money wages rise, the aggregate supply
curve (Z) shifts up, an observation emphasised by the Classical theorists. However, they overlooked the fact that
the money wage is also the significant determinant of income, which means that aggregate demand also shifted
when money wages rose. This observation – of the interdependency of aggregate supply and demand – thwarted
the simple Classical explanation that a money wage cut would cure mass unemployment.
In terms of the Classical solutions to unemployment, it was believed that one firm might be able to cut costs by
lowering wages for their workforce and because their demand will not be affected they might increase their
hiring.
However, if all firms did the same thing, total spending would fall dramatically and employment would also
drop. Again, trying to reason the system-wide level on the basis of individual experience generally fails.
The relevance of the Keynes versus Classics debate is that the same ideas are in dispute in the current era.
The conservative response to the persistent unemployment that has beleaguered most economies for the last
three or more decades is to invoke supply-side measures – wage cutting, stricter activity tests for welfare
entitlements, relentless training programs. But this policy approach, which reflects an emphasis on the labour
market and particularly, the wage rate falls foul of the fallacy of composition problem.
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Policy makers consistently mistake a systemic failure for an individual failure. The main reason that the supplyside approach is flawed is because it fails to recognise that unemployment arises when there are not enough jobs
created to match the preferences of the willing labour supply. That requires a system-wide policy response to
increase effective demand rather than an individual solution focusing on the characteristics of the unemployed.
Case study: The Parable of 100 Dogs and 93 Bones
Imagine a small community comprising 100 dogs. Each morning they set off into the field to dig for bones. If
there are enough bones for all buried in the field then all the dogs would succeed in their search no matter how
fast or dexterous they were.
Now imagine that one day the 100 dogs set off for the field as usual but this time they find there are only 93
bones buried.
Some dogs who were always very skilled at finding bones might dig up two bones and others will dig up the
usual one bone. But, as a matter of accounting, at least 7 dogs will return home bone-less.
Now imagine that the government decides that this is unsustainable and decides that it is the skills and
motivation of the bone-less dogs that is the problem. They are not skilled or motivated enough. Thus
considering the problem to be an individual one requiring an individualised solution.
So a range of dog psychologists and dog-trainers are called into to work on the attitudes and skills of the boneless dogs. The dogs undergo assessment and are assigned case managers. They are told that unless they train
they will miss out on their nightly bowl of food that the government provides to them while bone-less. They feel
despondent.
After running and digging skills are imparted to the bone-less dogs things start to change. Each day as the 100
dogs go in search of 93 bones, we start to observe different dogs coming back bone-less. The bone-less queue
seems to become shuffled by the training programs.
However, on any particular day, there are still 100 dogs running into the field and only 93 bones are buried
there!
The point is that fallacies of composition are rife in mainstream macroeconomics reasoning and have led to very
poor policy decisions in the past.
The Classical employment theory considered unemployment to be a transitory phenomenon – a disequilibrium
state – which would be quickly resolved if real wages were allowed to adjust to reflect underlying marginal
productivity.
Keynes was adamant that this was not the case. For him, mass unemployment was an equilibrium state, which
meant that it could persist indefinitely unless there was some “exogenous” intervention (from government
policy).
The Classics allowed for some transitory unemployment when the composition of aggregate output was
disrupted. So if there was a shift in demand from product A to product B, workers employed to make product A
might find themselves unemployed until they accepted jobs from firms making product B.
The Classics believed that real wage movements would ensure these resource transitions occurred. As we have
seen, they denied the possibility of a deficiency in effective (aggregate) demand.
Keynes showed that involuntary unemployment was an equilibrium state – in the sense that there are no
dynamics present that will change the situation. Firms would be producing and hiring at levels that were
consistent with their sales expectations and therefore would have no desire to change output levels.
But the Classical economists thought that the unemployed clearly desire higher consumption and would buy
more goods and services if they were working. It was hard for them to imagine how an excess supply of labour
(unemployment) and an excess demand for goods and services (the desire for more consumption) could co-exist.
Surely, price changes would resolve these imbalances.
They claimed that in the labour market the money wage would fall in response to the excess supply of labour,
and in the goods and services market, prices should rise in response to the excess demand for consumption
goods.
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One way of interpreting Keynes’ attack on the Classical theory is to focus on the nature of the excess supply of
labour and supposed co-existing excess demand for goods and services.
The fallacy inherent in the Classical faith in wage and price adjustments was first noted by Karl Marx (year) in
his Theories of Surplus value where he discusses the problem of realisation of sales when there is
unemployment. He was the first to understand the notion of effective demand. He made the distinction between
a notional demand for a good (a desire) and an effective demand (one that is backed with cash).
It is obvious, that the unemployed want to consume more but because they have no or little income they cannot
translate their notional desires into effective spending. Accordingly, the market, which relies on consumers
entering shops with money to purchase goods and services, fails to receive any demand signal from the
unemployed and so firms cannot respond with higher production.
This distinction between notional and effective demand was at the heart of the “Keynes and Classics” debate
during the Great Depression. It is central in his attack on Say’s law, which claimed that “supply creates its own
demand”. As we saw earlier in this Chapter, Say’s Law denies there can ever be over-production and
unemployment. If consumers decide to save more, then the firms react to this and produce more investment
goods to absorb the saving. There is total fluidity of resources between sectors and workers are simply shifted
from making iPods to making investment goods.
Keynes showed that when people save – they do not spend. Further, they give no signal to firms about when
they will spend in the future and what they will buy then. So there is a market failure. Firms react to the rising
inventories and cut back output – unable to deal with the uncertainty.
The theoretical push to reassert Say’s Law using the real balance effect as the conduit by which aggregate
demand would always adjust to aggregate supply came in the 1950s. But major theoretical work by Keynesians
such as – Robert Clower in 1965 [GET REFERENCE] and – Axel Leijonhufvud in 1968 [GET REFERENCE]
provided new insights into how we can see the contribution of Keynes and his demolition of Classical theory.
They demonstrated, in different ways, how neoclassical models of optimising behaviour were flawed when
applied to macroeconomic issues like mass unemployment.
Clower (1965) showed that an excess supply in the labour market (unemployment) was not usually accompanied
by an excess demand elsewhere in the economy, especially in the product market. Excess demands are
expressed in money terms. How could an unemployed worker (who had notional or latent product demands)
signal to an employer (a seller in the product market) their demand intentions?
Leijonhufvud (1968) added the idea that in disequilibrium, price adjustment is sluggish relative to quantity
adjustment. Leijonhufvud interpreted Keynes’s concept of equilibrium as being actually better considered to be
a persistent disequilibrium. Accordingly, involuntary unemployment arises because there is no way that the
unemployed workers can signal that they would buy more goods and services if they were employed.
Any particular firm cannot assume their revenue will rise if they put a worker on even though revenue in general
will clearly rise (because there will be higher incomes and higher demand). The market signalling process thus
breaks down and the economy stagnates.
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References
Australian White Paper on Full Employment (1945) DETAILS.
Beveridge, W. (1944) “Full Employment in a Free Society”, DETAILS…
Dunlop, J. (1938) “The Movement of Real and Money Wage Rates”– The Economic Journal, Vol. 48, No. 191
(September, 1938), 413-434)
Hansard (1929) HC Deb 15 April, Vol. 227, cc53-6, Winston Churchill 1929 budget speech –delivered Monday,
April 25, 1929 – available at: http://hansard.millbanksystems.com/commons/1929/apr/15/disposal-of-surplus.
International Labour Organization (ILO) (1964) (ILO, No. 22) “Unemployment Statistics”, available at:
http://www.ilo.org/global/statistics-and-databases/statistics-overview-and-topics/underemployment/lang-en/index.htm.
Keynes, J.M. (1936) “The General Theory of Employment, Interest, and Money”, available at:
http://ebooks.adelaide.edu.au/k/keynes/john_maynard/k44g/index.html.
Keynes, J.M. (1939) “Relative Movements of Real Wages and Output”, The Economic Journal, Vol. 49, No.
193 (March, 1939), 34-51).
Lerner, A. (1951) “The Economic Steering Wheel” in BOOK NAME HERE.
Marx,
K.
(1863)
“Theories
of
Surplus
Value”,
http://www.marxists.org/archive/marx/works/1863/theories-surplus-value/index.htm.
available
at:
Pigou, A. (1943) The Classical Stationary State, The Economic Journal, December, LIII, 343-51.
Ricardo, D. (1821) “On the Principles of
http://www.econlib.org/library/Ricardo/ricP5.html.
Political
Economy
and
Taxation”,
available
at:
Tarshis, L. (1939) “Changes in Real and Money Wages”, The Economic Journal, Vol. 49, No. 193 (March,
1939), 150-154).
Vickrey, W., (1992). "Chock-Full Employment without Increased Inflation: A Proposal for Marketable Markup
Warrants," American Economic Review, American Economic Association, vol. 82(2), pages 341-45, May].
Weintraub, S. (1956) 'A Macroeconomic Approach to the Theory of Wages', The American Economic Review,
45(5), December, 835-856.
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