Ch.

8: Unemployment

Lecture VIII
 The classical labor market
• Keynes, in his General Theory, claimed that equilibrium can
occur with employment below the full employment level.
• Classical economics regarded the labour market as self-
adjusting so that such an equilibrium cannot occur.
• The labor market in classical economics is thought to be
competitive and atomistic, i.e., individual workers and
employers behave separately as individuals rather than
combining in trade unions or employment associations.
• The supply of labor is assumed to be positively related to the
real wage, which implies that the substitution effect of an
increase in the wage outweighs the income effect.
• Substitution effect: the effect that induces more workers to
work and/or induces existing workers to work more hours.
• Income effect: the effect that induces workers to choose
more leisure and less work.
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• The demand for labour is assumed to depend inversely on
the real wage.
• In the classical model there is no involuntary
unemployment.
• In a competitive labor market, the real wage adjusts to
equilibrate supply and demand.
• The AS curve is derived from the labor market and
production function.
• The labor market is in equilibrium with employment and
real wage.
• The flexibility and self-adjusting properties of the classical
labor market ensure that whatever the price level, the real
wage is always (W/P)e, because money wages adjust
appropriately.
• Thus, whatever the price level, employment is Le and
output is Pe, and the AS curve is vertical
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The Keynesian-neoclassical debate
• The neoclassical critique of Keynes can be thought of as
starting from the classical model and arguing that
involuntary unemployment could occur in the Keynesian
model only because of rigidities in the labor market which
prevented the money wage adjusting to maintain the real
wage at its equilibrium level.
• If such rigidities existed, then the existence of involuntary
unemployment could be explained in terms of the classical
model of the labour market.
• This neoclassical critique implied that Keynes’s
contribution to economics lay not in any fundamental new
insight in economic theory but merely in his recognition of
the existence of money-wage rigidity.

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• Keynesian economists were inclined to regard the
money wage as inflexible at least in the short run,
but they rejected the neoclassical implication that
Keynes had contributed little to economic theory.
• Considering the question of whether there were any
automatic mechanisms by which unemployment
would be eliminated, Keynes argued: if wages fall
in response to unemployment, labor costs fall and
prices fall; this increases the real money supply
(Ms/P) and reduces the interest rate; and the lower
interest rate leads to higher inv’t and hence higher
income.
U  W (Ms/P)  r  I  Y 
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• Keynes effect: at any lower level, money wages
and prices fall and the LM curve shifts to the
right.
• Pigou effect: involves a wealth effect in the
consumption function: consumption is assumed to
be positively related to wealth as well as income, and
one of the components of wealth is the real money
supply (Ms/P).
– When prices fall, wealth rises and therefore
consumption increases.

U  W  P  Ms / P  C 
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• In the IS-LM model, this means that the IS curve
shifts to the right, and income increases.
• With Keynes effect shifting the LM curve to the
right and the Pigou effect shifting the IS curve to
the right, there is no combination of IS and LM
slopes for which income does not increase.

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• Keynesian economists were forced to concede that
the pigou effect exists in principle, but they argued
that it is likely to be relatively small in practice.
• This is b/c it operates only on ’outside’ money and
not on ’inside’ money which makes up the bulk of
the money supply.
• Inside money is money for which there exists a
corresponding private-sector liability.
• Most bank deposits come into the inside money
category since the liability corresponding to bank
deposits is the loans owed to the banks by other
private-sector agents or by the public sector.
• The private-sector holders of money balances find
themselves better off as the result of a price fall, b/c
their money balances have increased in real value.
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• Private-sector debtors who have outstanding bank
loans find themselves worse off, because their
debts are now larger in real terms.
• Hence, a negative wealth effect for private-sector
debtors, which is assumed to offset the positive
wealth effect for the private-sector holders of
money, so that the net effect of a price fall on
expenditure is zero for inside money.
• Outside money is money for which there is no
corresponding private-sector liability.

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• This means money which is ’backed’ by the debts of the
public sector, whether it is bank deposits for which the
corresponding liability is bank lending to the public
sector, or notes and coin issued by the central bank for
which the corresponding liability is gov’t debt to the
central bank.
• Here, it is assumed that the public sector does not feel
itself worse off and does not reduce its expenditure as the
result of the fall in prices, so that there is no negative
wealth effect offsetting the positive wealth effect for the
private-sector holders of money.
• Since most money is inside money and the Pigou effect
operates only on outside money, the effect of a given fall
in prices is likely to be small; conversely, a given increase
in expenditure from the wealth effect requires a large fall
in prices.
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• This means that the automatic self-equilibrating
mechanisms of the economy operate relatively
weakly, but they do operate provided money wages
are not completely rigid.
• The double recognition of the conditional existence
of these mechanisms, their weakness and the
assumption that money wages are in practice
relatively rigid downwards, constitutes the basis of
the ’truce’ between Keynesian and neoclassical
economists in which this debate ended in the 1950s
(Keynesian-neoclassical synthesis).

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• The Keynesian-neoclassical synthesis (or truce)
involved the agreement that if wages are not
completely rigid downwards, then there exist
automatic mechanisms in the economy which
would eventually restore full employment if the
economy moved away from that position; but
these mechanisms operate only slowly and weakly.
• The synthesis awarded the theoretical victory to
the neoclassicals but gave Keynesians the
justification required for a policy of systematic
macroeconomic intervention.

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 The Keynesian labor market
• In the Keynesian labor market, demand for labor is
downward sloping with respect to the real wage b/c
of diminishing returns to one factor when others are
fixed.
• The supply of labor involves a fixed money wage:
workers suffer from ”money illusion”, i.e., they
attach importance to and respond to money wages
rather than real wages.
• The supply of labor is perfectly elastic up to the full
employment level Lf at the fixed money wage W
• That there is no labor supplied at less than W but any
amount up to Lf is supplied at W .

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• At Lf there is full employment and no more labor
is supplied even if the wage is increased; the
supply of labor curve is therefore horizontal up
to Lf and vertical at Lf .
• In this figure, labor supply is drawn against the
money wage.

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 Conclusions
• The crucial results of the three models of labor market
concern the possibility of an unemployment equilibrium
and the role for macroeconomic stabilization policy.
• In the classical model, no unemployment equilibrium is
possible, the economy is always in a situation of no
involuntary unemployment, there is no gain from a policy
designed to stabilize output or employment.
• In the Keynesian-neoclassical synthesis model, the
downward rigidity of money wages ensures that an
unemployment equilibrium can occur. Stabilization policy
can move the economy towards the full employment level
but only at the cost of an increase in prices.
• In Keynesian model, money-wage rigidity makes an
unemployment equilibrium possible while the other
assumptions ensure that stabilization policy can restore
full employment without affecting prices.
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