The Economic Journal, 108 (May), 817±831. # Royal Economic Society 1998.

Published by Blackwell
Publishers, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA.

POST KEYNESIAN EMPLOYMENT ANALYSIS AND

THE MACROECONOMICS OF OECD
UNEMPLOYMENT

Paul Davidson

The Post Keynesian (hereafter PK) theory of employment is derived from

Keynes' chapter 3 (1936a) `The Principle of Effective Demand' where labour-
hire demand is derived from an effective demand point determined in the product
markets.1 Tobin (1992, p. 392) states this chapter is `the most important
innovation of the General Theory'. The effective demand principle means that
there is an `employment function' (Keynes, 1936a, ch. 20) relating alternate
labour-hire decisions to alternate points of effective demand. There is no aggre-
gate demand for labour schedule with the real wage as the independent variable
(Davidson, 1983).
Natural unemployment rate theories, however, (e.g., Phelps (1994, p. 10);
Layard et al. (hereafter LNJ) (1991, p. 20); Blanchard and Katz (hereafter
BK) (1997, p. 55) invoke the equivalent of an aggregate demand for labour
function under other names, e.g., a `price-setting relation' or a `demand wage
relation'. These latter functions depend on the `characteristics of the produc-
tion function . . . [and] the markup of price over marginal costs' (BK, 1997,
p. 55), i.e., aggregate labour demand is related to either the marginal
productivity of labour (MPL) or, in imperfect competition, the marginal
revenue product of labour (MRPL). Three restrictive axioms are required to
relate these marginal productivity functions to an aggregate demand for
labour curve. Keynes' revolutionary `principle of effective demand', however,
required overthrowing these classical axioms (Davidson, 1984). Keynes

1
Post Keynesians view the global economy as the equivalent of the closed system discussed in
Keynes's General Theory. The factors that determine aggregate employment for a (theoretical) closed
national economy are therefore applicable to a discussion of aggregate OECD employment. The
distribution of the resulting global employment constraint among the various trading partners as well
as relative employment growth among nations depends on many factors (just as the distribution of
employment among regions within a national economy). Among the major factor affecting relative
employment growth among trading partners (emphasised by Post Keynesians but virtually ignored by
mainstream theorists) is Thirlwall's Law of balance of payments constrained growth (see Davidson
(1994, pp. 220±2)). Other economists' proposals which can affect the distribution of employment
among nations within a global effective demand constraint including weakening national labour
market rigidities (i.e., bashing unions) to reduce money-wages, permitting child labour and=or unsafe
factories, etc. These latter proposals ultimately reduce nominal unit production costs and are policies
that beggar your neigbour by exporting your unemployment without devaluation. A recent ILO
(1996, p. xvi) report supports this PK view. (Space limitations do not permit a development of the
differences between a Post Keynesian analysis of the distribution of employment among OECD
nations and the mainstream explanation.)

[ 817 ]
818 THE ECONOMIC JOURNAL [MAY
(1936b, p. ix) explicitly wrote that his theory was `general . . . since it is based
on fewer restrictive assumptions'.2
By adopting the same axiomatic foundation as the old classical system,
natural unemployment rate analysis suffers the same shortcoming, namely that
the `characteristics' of these models happen `not to be those of the economic
society in which we actually live, with the result that . . . [their] teaching is
misleading and disastrous if we attempt to apply it to the facts of experience'
(Keynes, 1936a, p. 3).
Moreover natural rate theorists substitute a different meaning for the
concept of equilibrium from the one introduced by Marshall and used by
Keynes. In so doing, natural rate proponents de®ne away the problem of
involuntary unemployment equilibrium and are left with the same explanations
of observed unemployment that preKeynesian classical theorists invoked.
Unemployment is due to either frictions (mismatches) or the truculence of
workers (cf. Keynes, 1936a, p. 6).
My task is twofold. First, to provide (in Section 1) a PK explanation for
persistent high unemployment rates experienced by OECD nations since
1973. Second, so the reader can comprehend why this explanation differs
from that of NAIRU proponents, it is necessary to explore (Section 2) the
logical difference between Keynes's effective demand equilibrium model and
the more restrictive axiomatic system underlying the natural unemployment
rate concept. Section 3 demonstrates that natural rate explanations of
unemployment involve what Keynes (1936a, p.259) called an ignoratio elenchi,
i.e., the fallacy of offering proof irrelevant to the proposition in question.
Accordingly, only the PK analysis provides a basis for developing policies to
solve the OCED's persistent unemployment problem.

1. The Post Keynesian Explanation of OECD Unemployment

Bretton Woods formed the basis of the immediate postwar international
payments system. In large measure, this system was shaped by Keynes' thesis
that ¯exible exchange rates and free international capital mobility are
incompatible with global full employment and rapid economic growth in an
era of multilateral free trade (cf. Felix, 1997-8). Operating until 1973 under
an international trading system compatible with Keynes' `incompatibility
thesis', OECD nations experienced unparalleled growth and prosperity. The
average real GDP per capita growth rate for OECD nations between 1950 and
1973 was almost double the peak annual growth rate of the industrialising
nations during the Industrial Revolution, while labour productivity annual

2
Keynes (1936a, p. 16±7) noted that just as non-Euclidean geometry of curved spaces required the
throwing over of the axiom of parallels of Euclidean geometry, what `is required to-day in economics' is
throw out similar restrictive axioms of classical economics. Galbraith (1996) has cogently argued that
Einstein's general theory of relativity was an extension of non-Euclidean geometry to space-time
concepts and that Keynes attempted to apply to classical economics the same approach as Einstein's
revolution was to classical Newtonian physics.

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1998] POST KEYNESIAN ANALYSIS OF OECD UNEMPLOYMENT 819
growth was almost triple that of the Industrial Revolution (Adelman, 1991,
p. 17).
In the 1960s, economists developed open economy models based on the
classical axioms that Keynes had overthrown. These models `demonstrated'
that Keynes' incompatibility thesis was wrong. Instead free trade and optimum
global economic growth required a laissez-faire approach with ¯exible ex-
change rates and free capital mobility. Those who called themselves Neoclassi-
cal Synthesis Keynesians had already adopted microfoundations that required
these classical axioms for their closed economy models (Davidson, 1984).
Consequently, these `Keynesians' were easy prey for the classical counter-
revolution analysis of closed and open economies. Nevertheless, this successful
academic resurrection of the classical system would have not been suf®cient to
alter the policy mix if it were not for events of the 1970s.
The 1973 oil price shock created huge international payments imbalances
and unleashed in¯ationary forces in oil consuming nations. The resulting
economic dislocation placed policy makers in a dif®cult position. Under the
circumstances, politicians found irresistible the allure of the Panglossian siren
song that `all is for the best in the best of all possible worlds provided we let
well enough alone'. Without having to admit that they did not know what to
do, policy-makers used the conclusions of the 1960s classical counter-revolu-
tionary theories to justify their abandonment of any attempt to constrain
international ®nancial ¯ows and ®x exchange rates.
The resulting new international world of ®nance made the exchange rate
itself an object of speculation. Utilising new computer technology, ®nancial
capital could speed around the globe at the speed of light. Since the mid-
1970s, international ®nancial transactions have grown thirty times as fast as the
growth in international trade (Felix, 1997-8). International ®nancial ¯ows now
dominate trade payments. Exchange rate movements re¯ect changes in spec-
ulative positions rather than changes in patterns of trade.
Signi®cant exchange rate movements affect the international competitive
position of domestic vis-aÁ-vis foreign industries and therefore tend to depress
the inducement to invest in large projects with irreversible sunk costs. Since
1973, volatile exchange rates have made entrepreneurs more wary of under-
taking large investment projects.3 In an uncertain (nonergodic) world where
the future cannot be reliably predicted from past and present price signals,
volatile exchange rates undermine entrepreneurs' con®dence in their ability
to appraise the potential pro®tability of any large investment project. Every
exchange rate increase not only threatens domestic industries with signi®cant
loss of export-market share but also home-market share loss as imports become
less expensive. Managers realise that any upward blip in the exchange rate
during the lifetime of any contemplated investment project can saddle their
enterprises with irreversible costly idle capacity. Consequently, the marginal

3
While, at the same time they have vastly increased the liquidity demands of entrepreneurs, bankers,
and ultimately central bankers in terms of foreign reserve holdings.

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820 THE ECONOMIC JOURNAL [MAY
ef®ciency of investment is reduced.4 The greater the uncertainty regarding
future exchange rates, the less investment globally ± just as Keynes' (1936a,
ch. 17) analysis of liquidity preference and investment predicted. As a result,
trade and real investment spending in open economies have become the tail
wagged by the international speculative exchange rate dog.
It is not surprising, therefore, that when the free world changed from a ®xed
to a ¯exible exchange rate system, the annual growth rate in investment in
plant and equipment in OECD nations fell from 6% (before 1973) to less than
3% (since 1973). Less investment growth means a slower economic growth rate
in OECD nations (from 5.9% to 2.8%) while labour productivity growth
declined even more dramatically (from 4.6% to 1.6%).
This evidence is irrefutable. From a PK perspective, the pre-1973 period was
a golden age of economic development because both the international pay-
ments system and domestic ®scal and monetary policies tended to follow the
policy prescriptions that Keynes' principle of effective demand suggests (Da-
vidson, 1994, ch 16). Abandonment of the international monetary system that
embedded Keynes' `incompatibility thesis' principle is a major factor in
explaining why, since 1973, OECD economies have experienced slower eco-
nomic growth, rising global unemployment, and increasing inequalities of
income within each nation as well as between nations (Davidson, 1997).5
Restoring a golden age of low unemployment, rapid economic growth and a
stable international competitive structure that will allow nations to specialise in
their comparative advantage industries requires reforming the international
monetary system to embody the teachings of Keynes' effective demand prin-
ciple.
Since the 1970s, Tobin (1974) has been almost the only voice with signi®-
cant visibility in the economics profession warning that free capital markets
with ¯exible exchange rates can have a `devastating impact on speci®c
industries and whole economies' (Eichengreen et al. 1995). To avoid the real
economic havoc brought by volatile exchange rates, Tobin advocates that
governments constrain international ®nancial ¯ows via a `Tobin tax'. Else-
where I (Davidson, 1997) have suggested why a Tobin tax is too timid a
marginal adjustment and why effective demand analysis suggests that a more
fundamental reform of the international payments system is necessary.
Another post 1973 conventional wisdom (based on the axioms of classical
theory) has exacerbated the global depressing effect of volatile exchange rates

4
Volatility increases the possibility of an uncertain future and encourages entrepreneurs to
continually put off making investments. Hysteresis concepts have been used to explain why, when
volatility occurs, even when conditions for pro®ts brighten investors fail to undertake what would
appear to be pro®table investment projects under a more stable economic environment (Pindyck,
1991, p. 1134±5). Even in the long run, more volatility `implies a ®rm should hold less capital' (Pindyck
1991, p. 1139).
5
Recent studies by the ILO (1996) and the Luxembourg Income Study group (Gottschalk and
Smeeding 1997a, b) indicates widening inequalities are associated with increasing unemployment rates
of OECD nations except where a suf®cient social safety net has been maintained, e.g., Germany (and
Italy until 1985).

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1998] POST KEYNESIAN ANALYSIS OF OECD UNEMPLOYMENT 821
and free international ®nancial markets. It is that government spending is per
se undesirable and de®cit spending designed to increase the point of effective
demand employment is especially misguided. But `in a society where there is
no question of direct investment under the aegis of public authority [because
of a fear of de®cits], the economic objects, with which it is reasonable for the
government to be preoccupied, are the domestic rate of interest and the
balance of foreign trade' (Keynes, 1936a, p. 335).
When however, volatile exchange rates depress global investment spending
and de®cits are precluded, then if the worldly wisdom of central bankers is that
in¯ation can only be held in check by promoting the fear of `job insecurity'
among workers (Uchitelle, 1997, p. C6), then the rate of interest will be used
to perpetuate unemployment rather than promote prosperity. Subscribing to
the conventional wisdom rationalised by natural rate theories, politicians and
central bankers have foisted onto society a Hobson's choice that has devastat-
ing real effects on industry and the global economy.
I remind fellow economists of the wisdom of Keynes' (1936a, p. 349) dictum
that `In truth, the opposite [of the conventional wisdom] holds good. It is the
policy of an autonomous rate of interest, unimpeded by international preoccu-
pations, and of a national investment programme directed to an optimum
level of domestic employment which is twice blessed in the sense that it helps
ourselves and our neighbours at the same time. And it is the simultaneous
pursuit of these policies by all countries together which is capable of restoring
economic health and strength internationally, whether we measure it by the
level of domestic employment or by the volume of international trade'.

2. The Logical Difference: Keynes vs. a Natural Rate Analysis

Although Keynes' General Theory is a classic (if we de®ne a classic as something
everybody cites and nobody reads), natural rate of unemployment models
(e.g., Phelps (1994) and LNJ (1991)) are more widely read by the current
generation of economists than The General Theory. Consequently, an explana-
tion of Keynes' effective demand model is necessary to demonstrate why PK
believes Keynes' analysis, rather than the natural rate theory, is relevant to
today's global unemployment problem.
The point of effective demand, A in Fig. 1, is determined by the intersection
of Keynes' aggregate supply ( Z ) and demand (D) functions where the x-axis is
calibrated in employment units and the y-axis in money values6 (Keynes,
1936a, p. 41). The Z -function relates entrepreneurs' hiring decisions to their
aggregate expected sales revenue. Z is directly derivable from Marshallian
micro-supply functions and, like the latter, the aggregate supply curve's shape
and position depends strictly on the returns to labour, the money wage, and
Lerner's (1933±4) measure of the degree of monopoly (see Davidson, 1987).

6
Or in Fig. 3 the y axis is calibrated in wage units, i.e., money values de¯ated by the money wage
rate.

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822 THE ECONOMIC JOURNAL [MAY
The D-function consists of two types of spending. D1 spending is de®ned as all
expenditure-¯ow that depends on aggregate employment and income ¯ows
(e.g., the propensity to consume) while D2 spending is all spending not related
to current income ¯ows (e.g., investment, government and exports) (Keynes,
1936a, pp. 28±30). Effective demand point A in Fig. 1 (and Fig. 3) represents
equilibrium in the product market where the expectations of sales by pro®t
maximising entrepreneurs are just being met by the spending decisions of
buyers. At the point of effective demand there is no reason (endogenous
force) that causes entrepreneurs to alter their production, pricing and hiring
decisions as long as the determinants of the Z- and D-functions remain unchanged.
Keynes distinguished an entrepreneurial, money-using economy from a
classical non-monetary, real exchange system. The latter is a `special case' of a
general theory where the imposition of three restrictive classical axioms are
required to assure that instantaneously ¯exible prices assure full employment
(and, in modern classical models, assures consistent expectations of all
economic agents). The requisite classical axioms are: (i) money is always
neutral (at least in the long run), (ii) the future can be (statistically) reliably
predicted using past and current (relative) price signals (the ergodic axiom7 );
therefore participants' expectations are `correct'8 at least in the long run and
(iii) everything is a substitute for everything else (the gross substitution
axiom).

Expected sales
revenue,
planned spending
(money values) Z

Na Employment

Fig. 1.

7
In nonstochastic models, the ordering axiom plays the same role as the ergodic axiom (Davidson,
1991, p. 134; Hicks, 1979, pp. 113, 115).
8
Mutually correct expectations of entrepreneurs and workers are the basis of both Phelps' and LNJ's
concept of equilibrium.

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1998] POST KEYNESIAN ANALYSIS OF OECD UNEMPLOYMENT 823
Real wage rate
LS

A′
Wra
F′

MECL
Wras

Na Nf Nb Employment

Fig. 2.

Zw
Expected sales
revenue,
planned spending
(wage unit)
F D ′w

Dw
A

Na Nf Employment

Fig. 3.

In contrast, an entrepreneurial economy is a market-oriented system where people

use money and contracts to deal with an uncertain future. In this uncertain
world, people `do not know what is going to happen and they know they do
not know . . .. As in history' ( Hicks, 1977, p. vii). In terms of stochastic models,
this concept of uncertainty means that agents know that past and current
market (price) signals do not provide a statistically reliable basis for making
probability statements regarding future outcomes. The ergodic axiom there-
fore can not be used to explain behaviour underlying decisions (e.g., invest-
ment) where agents believe the future is uncertain rather than just risky.
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824 THE ECONOMIC JOURNAL [MAY
Lucas (1977, p. 15) has argued that `in the cases of uncertainty [i.e.,
nonergodic conditions] economic reasoning will be of no value'. Keynes
(1937a), on the other hand, argued that his effective demand reasoning dealt
speci®cally with an uncertain (nonergodic) environment9 rather than merely a
risky economic system.
In nonergodic conditions, there is great utility in organising production and
exchange activities via time-duration money contracts that limit liabilities to
nominal sums. In such a monetary-entrepreneurial economy, ®rms and house-
holds are concerned not just with their real income but also with their cash
¯ows. No matter how unpredictable (nonergodic) the `real' future is, agents
can avoid the pain of bankruptcy as long as cash in¯ow exceeds out¯ow. The
use of non-indexed nominal contracts to organise economic activities, allows
®rms and households to gain control of cash ¯ows in an uncertain environ-
ment. Models of optimising agents that produce `correct' and consistent
expectations of future real ¯ows may be an idealised objective, but it is nigh
impossible to achieve in the real world as Robert Burns recognised when he
wrote `the best laid schemes o'mice an' men gang aft agley'. Controlling
nominal cash ¯ows by using money contracts to avoid bankruptcy, however, is
an attainable and useful objective and is, therefore, the basis of most expendi-
ture decisions in an entrepreneurial economy ± as the businessman's `put-
down' of the classical academic economist `They have never had to meet a
payroll' clearly suggests.
In a monetary economy, sensible entrepreneurs enter into monetary forward
contracts for the hire of labour and other factor inputs. As long as entrepre-
neurs have, or can contractually arrange to obtain, the necessary liquidity (cash
holdings plus net cash in¯ows) to meet contractual cash-out¯ow obligations as
they come due, they need not fear an uncertain `real' future. Liquidity, therefore,
affects entrepreneurial decisions to produce real output and hire-workers. In
an entrepreneurial economy, it is cash-¯ow conditions that determine produc-
tion and employment-hiring decisions.
Money is never neutral in either the short- or long-period as long as
entrepreneurs continue to organise production with a myriad of overlapping
and concomitant money contracts.10 In an entrepreneurial system, neither the
ergodic axiom nor the neutral money axiom apply. Any model built on the
microfoundation of ergodicity and neutral money provides a misleading
explanation of important economic expenditure decision-making and hence
can provide dangerous policy implications for our real economy.
Keynes (1936a, p.16) recognised the need to `throw over' these classical
axioms. The resulting employment model has four fundamental attributes that

9
Although Keynes never used the term `ergodic', Keynes' (1937b, p. 308) criticism of Tinbergen's
`method' is that the economic system in which we live is not stationary, and nonstationarity is a
suf®cient condition for nonergodicity.
10
Any economy that abandons the use of money contracts must revert to some form of a completely
centralised co-operative system with very primitive production processes (e.g., as in a nunnery or
kibbutz).

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1998] POST KEYNESIAN ANALYSIS OF OECD UNEMPLOYMENT 825
are missing from classical models but are relevant to money-using, market-
oriented economies:
1. There is no aggregate demand for labour function with the real wage as the
independent variable. Neither a MPL function nor a MRPL concept (obtained by
multiplying MPL by a scalar inversely related to Lerner's (1933±4) degree of
monopoly11 ) nor any other productivity based labour-demand analysis (e.g.,
LNJ, 1994, p. 341; BK, 1997, p. 55) can provide an aggregate demand curve for
labour. Any productivity-based function purporting to relate the real wage paid
by employers to labour-hire decisions must be interpreted as, in Patinkin's
(1965, pp. 391±2) terminology, `a market equilibrium curve' of labour-hire
(hereafter MECL). The MECL speci®es the real wage outcome associated with
alternative equilibrium employment levels where both the equilibrium real wage
paid and workers-hired are determined by the point of effective demand in the product
markets.
2. Involuntary Unemployment Equilibrium can exist in both the short- and long-period.
Natural rate theorists restrict the equilibrium concept to a `state of correct
expectations'12 (Phelps, 1994 p. 10) (also LNJ 1991, pp. 12±4). Keynes and
PK, however, de®ne equilibrium in what Patinkin (1956, p. 643) noted is `the
usual sense of the term that nothing tends to change in the system'. Under this
more general (usual) de®nition, entrepreneurs are achieving their pro®t-
maximising expectations at effective demand point A in Fig. 1. If at point A
there are any involuntarily unemployed workers, they are disappointed, i.e.,
their real wage-labour supply expectations are not met, even in the long run.13 In a
monetary economy, unemployed workers have no mechanism available to
them to induce entrepreneurs to change their production, hiring and pricing
decisions and hire additional workers as long as the entrepreneurs' pro®t-
maximising expectations are being met.
Even if the unemployed force down money-wages, unless the point of effective
demand increases, employers, in the aggregate, would still hire the same volume
of employment. Figs 1, 2 and 3 can be used to explain this point. At the point
of effective demand A in Fig. 1, pro®t-maximising entrepreneurs hire N a
workers. Although there is no aggregate demand for labour curve there is a
market equilibrium curve for labour-hire (MECL) that we will simply assume is
downward sloping.14 In Fig. 2 this MECL curve is placed against a traditional
upward sloping labour supply (LS) curve that shows the volume of labour

11
Lerner's degree of monopoly (ˆ ( p ÿ mc)= p) where p is the pro®t maximising price and mc is
the marginal cost) is equivalent to the reciprocal of the absolute value of the price elasticity of demand
facing the ®rm in less than perfect competition.
12
This `correct' expectations concept is the equivalent of the old classical perfect certainty
condition.
13
By rede®ning equilibrium as `a state of correct expectations', Phelps (1994, p. 10) de®nes away
the possibility of involuntary unemployment equilibrium in Keynes' sense where unemployed workers'
expectations of being hired at the market real wage are disappointed and therefore they hold
`incorrect' expectations.
14
The analysis in this paragraph is still relevant even if the MECL curve is either horizontal (constant
returns) or upward sloping (increasing returns to labour).

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826 THE ECONOMIC JOURNAL [MAY
willing to work (without shirking).15 Given the effective demand point A,
where the equilibrium level of hired workers is N a the MECL curve indicates
that the equilibrium real wage determined at point A is w ra . The LS curve in
Fig. 2 indicates that this real wage is greater than the marginal disutility (w ras )
of N a workers, i.e., w ra . w ras . The LS curve also indicates that N b workers
would be willing (and quali®ed) to work at the market real wage of w ra .
Involuntary unemployment is (N b ÿ N a ). Fig. 2 provides an exact match to
Keynes' (1936a, p. 30) description of involuntary unemployment.
Now de¯ate all nominal variables in Fig. 1 by the money wage rate and
transfer the resulting wage-unit D- and Z -functions to Fig. 3 where the y axis is
in terms of Keynes' wage-unit. Fig. 3's recalibrated Z -function is independent
of the money wage, i.e., any change in the money wage per se will not alter the
shape or position of the Z -function measured in wage units. Thus when both
D- and Z -functions are in wage-unit terms, at effective demand point A in Fig.
3 there are involuntarily unemployed workers whose expectations are not
being met. Even if these workers were instantaneously to force down the money-
wage, Fig. 3's Z -function would remain unchanged. Disappointed unemployed
workers, therefore, can reduces money wages until they are blue in the face
without altering entrepreneurs' `correct' pro®t-maximising-hiring decisions
one iota unless the money-wage induces an increase (upward shift) of the
D-function denominated in wage-units to Fig. 3's dotted D function.
Using this Keynes' principle of effective demand analysis means that any
model (e.g., Phelps' or LNJ s) that claims to demonstrates that a policy that
aims directly and solely at lowering the real wage received by the employed will
increase aggregate hiring-decisions is offering a proof that is not relevant to
the question of how involuntary unemployment can be reduced in the
entrepreneurial money-using, market economies of the OECD. We should not
take any recommendation that lowering the real wage will automatically
increase employment unless, and until, the proponents of natural unemploy-
ment rate models demonstrate that lowering the real wage will necessarily
increase the point of effective demand.16

15
The labour supply curve shows the supply price (real wage) for alternative labour supply offerings.
Marshall (1950, p. 142) de®ned the supply price as `the price required to call forth the exertion
necessary for producing any given amount of a commodity [or service]'. Labour's supply price is the
real wage that is required to induce workers to exert a given amount of effort that entrepreneurs
demand for a day's real wage. Assuming homogeneous labour units, entrepreneurs are `indifferent' to
which unit of the available labour force is actually hired.
Shirking is an ad hoc constraint used by natural rate proponents to explain real world unemployment
by providing a scapegoat in terms of `lazy', if not dishonest, workers who will not give an honest day's
work for an honest day's pay. Yet no one suggests a `shirking butcher theory of unsold meat' because
consumers have to pay above market clearing prices to encourage butchers not to sell a 15 ounce-
pound of meat. Nor should we have a shirking theory of unemployment.
16
Phelps' (1994, p. 154±5) offers a proof that employment will increase if, ceteris paribus, there is a
shift from payroll taxes to VAT (without altering revenues and government spending) because an
income tax produces a higher (before tax) real wage than a VAT, given the money wage and pro®t
maximising price setting by employers. Given the money-wage, Phelps argues that entrepreneurs pass
forward in product prices the entire VAT, so that the real wage is lowered, and therefore ceteris paribus
employment is greater. Until Phelps explains why changing the form of the tax per se increases the
point of effective demand in Fig. 3, he has provided the reader with a proof that is irrelevant to the
proposition.

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1998] POST KEYNESIAN ANALYSIS OF OECD UNEMPLOYMENT 827
Even if natural rate theorists could provide such a demonstration, if the
purpose of their policy is ultimately to increase the effective demand point,
then one might legitimately inquire `why not just raise effective demand
directly without the subterfuge of forcing down the real wage?'. Surely a policy
aimed at deliberately reducing the real wage will foment political and social
discontent. Any policy that increases the point of effective demand, on the
other hand, will encourage entrepreneurs to hire more workers. Whether the
resulting real wage declines or not depends on the supply conditions of
returns to labour and, in imperfect competition, on changes in the product
demand-price elasticities that underlay the Z -function (as LNJ (1991, pp.
341±2) recognise).
3. Money is never neutral in either the short run or long run (Keynes, 1934, p. 409) as
nominal contracts are used to control cash ¯ows in an uncertain world. Yet
Phelps (1994, pp. 405±6) and LNJ (1991, p. 362) admit that their models
involve a `nonmonetary' economy, or at least one where money is neutral.
According to the principle of effective demand, however, a money-using
economy will never be automatically self-adjusting to any full employment rate
(or natural unemployment rate) and `without purposive direction it is incap-
able of translating actual poverty [involuntary unemployment] into potential
plenty [full employment]' (Keynes, 1934, p. 491).
4. Money provides liquidity because it possesses two essential elasticity properties (Key-
nes, 1936a, ch. 17, see especially p. 241, n. 1). First, its elasticity of production
is (approximately) zero, i.e., money does not grow on trees. Readily producible
goods (i.e., things with high elasticities of production), therefore can never ®ll
the liquidity role played by money.17
Second, the elasticity of substitution between all liquid assets (including
money) and the products of industry is (approximately) zero. The private sector,
therefore, will not reallocate labour from producing goods to harvesting
money from the money tree if people decide to spend less of their income on
the products of industry and plan to use the resulting saving to become more
liquid i.e, by storing this saving in the form of money or other liquid assets and
thereby raise the price of nonproducibles liquid assets relative to producibles.
Hahn (1977, p. 39) implicitly utilises these elasticity properties when he
demonstrates that the existence of `any nonreproducible asset [i.e., a durable
that has a zero elasticity of production] allows for a choice between employ-
ment inducing and non-employment inducing demand. But, of course in a
monetary economy money is an important nonreproducible asset'. The only
necessary condition for the existence of involuntary unemployment equili-
brium is that there are `resting places for saving [in] other than reproducible

17
In contrast, Walrasian theory suggests that money is merely a numeraire and can be any readily
producible commodity. If we are to believe Friedman (1968, p. 8) who stated `The natural rate of
unemployment is the level ground out by the Walrasian system . . .', then natural rate theories require a
money that does not possess these elasticity properties. (In fact, in his debate with me, Friedman (1974,
pp. 152±3) argues that these elasticity propertes are not relevant.) Consequently we should apply
natural rate theory only to an economy where money is a readily producible commodity such as peanuts
± and not to the international global economy of OECD.

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828 THE ECONOMIC JOURNAL [MAY
assets'18 (Hahn, 1977, p. 31), i.e., producibles are not substitutes for money
(or liquid assets) for storing value (saving) and therefore the gross substitution
axiom is not applicable.

3. Is There a NAIRU in an Entrepreneurial Economy?

I tell my students that the best way to evaluate any theory is to consider the
model builder `as if' she is a stage magician. Carefully examine the rabbits put
into the hat backstage by model-builders to understand how model-builders
pull speci®c policy rabbits out of the black hat (model). The more surprising
the rabbits pulled from the hat, the greater the audience enjoyment and
applause.19
Nowhere is this rabbit in, rabbit out analogy more appropriate than with the
claim that NAIRU represents an `unemployment' equilibrium position (see
Rogerson, 1997, pp. 73±4). While the natural rate theory has an appearance of
being modern, it represents old (classical) wine marketed in new bottles.
Using Figs. 2 and 3 we can see this by translating LNJ's model into Keynes'
effective demand analysis for an entrepreneurial economy where the money-
wage contract is the most universal of all contracts. Entrepreneurs use (for-
ward) money wage contracts to ®x their nominal payroll liabilities (cash
out¯ows) for the duration of a production cycle. Once their nominal costs
(and hence marginal costs) are ®xed by contracts, pro®t maximisers will `set'
their product price relative to marginal costs based on the demand price
elasticity embedded in the particular Marshallian demand schedule that each
®rm faces (LNJ, 1991 pp. 341ff). Any speci®c product demand curve, however,
exists only for a speci®c point of aggregate effective demand (Keynes, 1936a,
p. 259). Every time the point of effective demand changes, there will be a new
demand curve facing every ®rm in the economy.
Thus, in Fig. 3, if A is the point of effective demand, the costs embodied in
nominal contracts and the price elasticities associated with product demand
curves derived from this effective demand point are the determinants of the
relationship between product prices and the money wage. Fig. 2 can then be
interpreted as a direct translation of LNJ's (1991, p.14) diagram where the
MECL is equivalent to LNJ's `price-setting' equation and the LS is LNJ's `wage-
setting' equation. The intersection of the two curves at F 9 in Fig. 2 indicates
that when the equilibrium level of employment is N f , the price-setting equa-
tion of entrepreneurs is consistent with the wage setting equation of workers.
At F 9 the real wage expected by workers (as a measure of the marginal disutility
of labour) will equal the real wage paid by entrepreneurs. Accordingly, F 9

18
Hahn (1977, p. 37) also notes that in an economy where money is a nonreproducible asset, `the
view that with ``¯exible'' money wages there would be no unemployment has no convincing argument
to recommend it'.
19
A careful examination of the rabbits put into the hat is prerequisite for evaluating the policy
rabbits pulled from the hat. If the rabbit put into the hat is an obvious misrepresentation of our world,
then invoking the name of `tractable science', is not a suf®cient reason for accepting inapplicable rabbit
axioms that even their breeder admits are `patently false' (Lucas, 1981, p. 563).

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1998] POST KEYNESIAN ANALYSIS OF OECD UNEMPLOYMENT 829
represents the classical full employment situation (Keynes, 1936a, pp. 15±6).
F 9 will be operational only if the point of effective demand, F in Fig. 3 is at the
full employment level N f (i.e., at the intersection of the dotted D9-function
with the Z -function in Fig. 3). As long as effective demand is only at point A
(in Fig. 3), however, the A9 point on the MECL curve in Fig. 2 depicts the
resulting involuntary unemployment equilibrium and real wage being paid.
These will remain unchanged as long as the determinants of the Fig. 3's solid
line D- and Z -functions are unchanged.
Natural rate theories are con¯ating the natural rate of unemployment with
old classical full employment. Because natural rate theorists (e.g., LNJ) use
logarithms for price and money wage variables instead of the arithmetic price
and quantity variables used in old classical models, the natural rate theories
associate the classical full employment rate with a constant rate of in¯ation
rather than with the classical constant price level at full employment. The label
of a (dynamic) `natural rate of unemployment' theory may be different from
the (static) old classical `full employment' model, but the alcoholic content is
the same.
Keynes (1936a, pp. 300±3) and PK have always recognised that in¯ation can
occur before full employment whenever rising money-wage rates (the wage-
unit) increase marginal costs and therefore pro®t-maximising product prices.
Increases in the money-wage before full employment may be due to all sorts of
cultural and institutional conventions where the latter re¯ect `the psychology
of workers and the policies of employers and trade unions' (Keynes, 1936a,
p. 301). Thus to prevent cost-unit in¯ation before full employment requires an
incomes policy (see Keynes, 1930, pp. 168±9) in tandem with an educational
policy to explain to workers and ®rms that any attempt to increase money
wages faster than productivity increments in the hopes of improving one's real
wage will either be frustrated by the resulting in¯ation, or if successful for any
speci®c group of workers it will have been accomplished at the expense of
other less truculent, members of society.20

4. Conclusion
The proposition in question in this controversy is: given the obvious histori-
cally high rates of unemployment in OECD nations since 1973, what policies
should be undertaken to restore unemployment rates to those that occurred
in the 1950s and 1960s in the OECD? The onus is on those who advocate
speci®c policies aimed directly and solely at reducing the real wage rate to
demonstrate in an uncertain (nonergodic) world stripped of neutral money

20
The ILO's report on World Employment 1996=97 (1996, pp. xvi-xvii) echoes our PK perspective. The
ILO states `There is, however, no convincing evidence that it is supply-side constraints, rather than a
de®ciency in demand that have caused the prolonged period of low growth {and high unemployment
globally]. Higher growth is possible provided a sustained period of expansionary policies is supported
by credible policies to prevent a resurgence of in¯ationary wage pressures . . . the adoption of some
form of tax-base incomes policies'.

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830 THE ECONOMIC JOURNAL [MAY
and without an aggregate demand for labour curve related to the MPL, that
their speci®c policies will automatically increase the point of effective
demand.
Elsewhere (Davidson, 1997) I have presented a PK revision of Keynes' 1940s
proposal for reforming the international payments system in line with Keynes's
incompatibility thesis. This proposal in tandem with Keynes' argument to use
interest rate policy and government cooperation with private investment
initiatives to achieve full employment will produce a new Golden Age for the
global economy in the 21st century.
University of Tennessee

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