AD/AS models and the ‘disappearance’ of involuntary unemployment

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Lars Pålsson Syll
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AD/AS models and the ‘disappearance’ of involuntary unemployment

We have indeed come round in a circle. The whole vision of the working of the macrosystem presented, in terms of the AD/AS model, by far too many contemporary textbooks, is essentially pre-Keynesian. Monetary spending may fluctuate, but whether or not such fluctuations affect employment and output is said to depend on reactions affecting real wages. Slow adjustment of money wages to price changes is held to account for cyclical variations in employment and output. With respect to the longer term, it is presumed that real wages return to their proper full-employment level …

As regards the fundamental elements of the Keynes conception … all have disappeared.

How have we got into this situation? In the 1970s, reflecting a general change in the political and intellectual climate, economic theorists and commentators of a right-wing, free-market persuasion began to advance, with renewed vigour, old ideas which had for the last few decades been put to the side. Under novel labels such as ‘New Classical’ and ‘New Keynesian’ theory, explanations of unemployment being simply of a voluntary or merely frictional character were reasserted, attracted sympathetic listeners and soon found their way into the burgeoning crop of macro textbooks coming on the market. Over the years distinctive features of the Keynes theory – such as the concepts of involuntary unemployment, of the marginal efficiency of capital as distinct from the marginal productivity of capital, of uncertainty as something different from mathematically measurable risk, and the understanding that the macro economy contained within itself, even in the long run, no reliable self-righting mechanism to guarantee the automatic establishment of full employment – tended to slip out of the mainstream picture. Indeed, more than that: the Keynes theory is frequently misrepresented – it is typically asserted that an assumption of wage-stickiness is the critical factor differentiating the Keynes theory from the classical theory. Scholars who should have known better have been all too ready to adopt the old classical labour market theory of unemployment as embodied in the AS curve, apparently seeing the AD/AS model as a convenient and acceptable device for allowing analysis to be extended beyond the fix-price world of IS/LM. The upshot is that mainstream teaching of macroeconomic theory is today typically propounding a view of the working of the economy which is a very long way from the vision presented in the General Theory or from the conventional wisdom of the immediate post-war years, but strikingly similar to views current long ago, before the ‘Keynesian Revolution’. It is not going too far to say that the practical common-sense of the Keynesian perspective has (at least in some not un-influential quarters) been replaced by irrelevance and fantasy.

Roy H. Grieve

As Grieve notices, there are unfortunately a lot of mainstream economists out there who still think that price and wage rigidities are the prime movers behind unemployment. What is even worse — I’m totally gobsmacked every time I come across this utterly ridiculous misapprehension — is that some of them even think that these rigidities are the reason John Maynard Keynes gave for the high unemployment of the Great Depression. This is of course pure nonsense. For although Keynes in General Theory devoted substantial attention to the subject of wage and price rigidities, he certainly did not hold this view.

Since unions/workers, contrary to classical assumptions, make wage-bargains in nominal terms, they will – according to Keynes – accept lower real wages caused by higher prices, but resist lower real wages caused by lower nominal wages. However, Keynes held it incorrect to attribute “cyclical” unemployment to this diversified agent behaviour. During the depression money wages fell significantly and – as Keynes noted – unemployment still grew. Thus, even when nominal wages are lowered, they do not generally lower unemployment.

In any specific labour market, lower wages could, of course, raise the demand for labour. But a general reduction in money wages would leave real wages more or less unchanged. The reasoning of the “classical” economists was, according to Keynes, a flagrant example of the “fallacy of composition.” Assuming that since unions/workers in a specific labour market could negotiate real wage reductions via lowering nominal wages, unions/workers in general could do the same, the classics confused micro with macro.

Lowering nominal wages could not – according to Keynes – clear the labour market. Lowering wages – and possibly prices – could, perhaps, lower interest rates and increase investment. But to Keynes it would be much easier to achieve that effect by increasing the money supply. In any case, wage reductions was not seen by Keynes as a general substitute for an expansionary monetary or fiscal policy.

Even if potentially positive impacts of lowering wages exist, there are also more heavily weighing negative impacts – management-union relations deteriorating, expectations of on-going lowering of wages causing delay of investments, debt deflation et cetera.

So, what Keynes actually did argue in General Theory, was that the “classical” proposition that lowering wages would lower unemployment and ultimately take economies out of depressions, was ill-founded and basically wrong.

To Keynes, flexible wages would only make things worse by leading to erratic price-fluctuations. The basic explanation for unemployment is insufficient aggregate demand, and that is mostly determined outside the labor market.

It is not very plausible to assert that unemployment in the United States in 1932 was due either to labour obstinately refusing to accept a reduction of money-wages or to its obstinately demanding a real wage beyond what the productivity of the economic machine was capable of furnishing. Wide variations are experienced in the volume of employment without any apparent change either in the minimum real demands of labour or in its productivity. Labour is not more truculent in the depression than in the boom — far from it. Nor is its physical productivity less. These facts from experience are a prima facie ground for questioning the adequacy of the classical analysis …

The classical school [maintains that] while the demand for labour at the existing money-wage may be satisfied before everyone willing to work at this wage is employed, this situation is due to an open or tacit agreement amongst workers not to work for less, and that if labour as a whole would agree to a reduction of money-wages more employment would be forthcoming. If this is the case, such unemployment, though apparently involuntary, is not strictly so, and ought to be included under the above category of ‘voluntary’ unemployment due to the effects of collective bargaining, etc …

The classical theory … is best regarded as a theory of distribution in conditions of full employment. So long as the classical postulates hold good, unemploy-ment, which is in the above sense involuntary, cannot occur. Apparent unemployment must, therefore, be the result either of temporary loss of work of the ‘between jobs’ type or of intermittent demand for highly specialised resources or of the effect of a trade union ‘closed shop’ on the employment of free labour. Thus writers in the classical tradition, overlooking the special assumption underlying their theory, have been driven inevitably to the conclusion, perfectly logical on their assumption, that apparent unemployment (apart from the admitted exceptions) must be due at bottom to a refusal by the unemployed factors to accept a reward which corresponds to their marginal productivity …

J M Keynes General Theory