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

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

from Lars Syll

eco-202-ch-36-unemployment-and-inflation-15-638We 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

  1. August 7, 2016 at 9:05 am

    It seems to me the AD/AS diagram above is not a model of a working economy but a graph of Quantity of Output against Price. Keynes’s “perfectly logical conclusion” is double-sided, for applied to the Price of labour the long-run Quantity of Working Lives (arguably the whole point of economics) can be held lower than it might be by employers being unwilling to pay the optimum price. In short, this is Malthus’s laissez-faire theory of population control disguised by abstracting the reality from it, and hence the evidence that lives may be lengthened and population levels increased by better distribution and health care technology as well as good harvests. What hasn’t happened in both economics and population control has been a grasp of PID control theory and organisation of the information feedbacks necessary to implement it.

  2. Paul Davidson
    August 7, 2016 at 5:41 pm

    Keynes explicitly denied hat his theory required rigidity in money wages and/or prices on page 257 Keynes wrote: “the Classical Theory has been accustomed to rest the supposedly self adjusting character of the economic system on an assumed fluidity of money wages: and when there is rigidity to lay on this rigidity the blame for maladjustment….My difference from this theory is primarily a difference of analysis”

    . In Chapters 17-19 of The General Theory, using Marshallian (and not Walrasian) microfoundations, Keynes demonstrated that as a matter of logic involuntary unemployment could occur even in purely competitive economy with freely flexible wages and prices. Keynes [1936a, p.259] indicated that to assume that a rigidity in money wags was the sole cause of the existence of an unemployment equilibrium implied accepting the argument that Marshallian micro-demand functions “can only be constructed on some fixed assumption as to the nature of the demand and supply schedules of other industries and as to the amount of the aggregate effective demand. It is invalid, therefore, to transfer the argument to industry as a whole unless we also transfer our assumption that the aggregate effective demand is fixed. Yet this assumption reduces the argument to an ignoratio elenchi”.

    To understand this argument further read my new book POST KEYNESIAN THEORY AND POLICY.

    • August 7, 2016 at 10:57 pm

      My reference to Keynes’s “perfectly logical argument” was ambiguous. I’d intended to refer to his quotation, not to the argument being Keynes’s, which of course – as it was then being interpreted – it wasn’t. But the point of my argument, Paul, was to agree with you, your Keynesian argument being strengthened by mine independently reaching the same conclusion.

      In the graph shown (which I gather may not have been available to Keynes), exchanging the principle and dependent variables reveals that the employers would get better employment outcomes by choosing to pay higher wages and thereby attract more labour rather than seek to minimise wages. On their own argument (i.e. the one they had imbibed from neoliberal economics), it was their rigidly choosing to minimise labour costs, not workers seeking excessive wage rates, which led to the persistence of involuntary unemployment which Keynes observed, explained and, blessedly, for a time overcame.

  3. August 9, 2016 at 6:23 am

    Reading this post reminds me of your other post wherein you mention The Great Geographer who is too occupied with his scientific work to be able to say anything about reality.

    I sent a paper with what seems to me a definitive (or at least a very plausible) explanation of involuntary unemployment without requiring wage rigidity to quite a few economists. Only one economist has bothered to reply.

  4. August 9, 2016 at 11:32 am

    I forgot to add that the paper shows mathematically that the aggregate demand curve is vertical during recessions.

  5. Norman L. Roth
    August 11, 2016 at 3:52 am

    August 11, 2016

    With all due respect, Messrs. Lars Syll and Paul Davidson, you are raking over the same old ashes that have preoccupied three generations of cul-de-sac thinking. Keynes described the restraining conditions of his paradigm at the beginning of Chapter 18 of the GENERAL THEORY: They were the same as the Walrasian ones. Tastes and the technology of production are held constant. Where else was Keynes to go in order to explain fluctuations in “involuntary” unemployment other than in variations in investment and savings ?
    Please go back to “Why does Aggregate Demand Collapse” ? .Nov. 07,2014. Scroll right the way down to Norman L. Roth. .And combine it with Gunnar Myrdal’s classic, definitive put-down of General Equilibrium’s to explain much of anything at the macro-economic level.

    GOOGLE {1}Norman L. Roth {2} Norman L. Roth, economist {3} Norman L. Roth, Economics of Work {4} Norman L. Roth, Origins of Markets

  6. Paul Davidson
    August 11, 2016 at 6:09 pm

    Norman –perhaps you chapter 17 before you tell us to read chapter 18. Chap. 17 is”The Essential Properties of Interest and Money” –where Keynes argues all liquid assets have these essential properties — namely (1) the elasticity of production is zero or negligible, i.e., all liquid assets are essentially nonproducibles and (1) the elasticity of substitution between liquid assets and producibles is zero or negligible! This explains why Keynes’s general theory can explain involuntary employment ca exist , even given existing techniques, tastes of consumers, etc. In Chapter 17 , Keynes explains why even with perfectly flexible wages and prices, a market economy can exhibit involuntary unemployment! If you want a full understanding please read my book POST KEYNESIAN THEORY AND POLICY!

    Paul Davidson

  7. Norman L. Roth,
    August 25, 2016 at 5:14 pm

    August 25, 2016

    The macro-economic history of fluctuations in “involuntary unemployment” cannot even be approached by the essentially monetary-behavioural trade-off – explanations, of Keynes, Milton Friedman, Irving Fisher et al: Nor by the politically driven,”finance-capital”, manufactured instability, ‘army of unemployed’ conspiracy theories of “progressives” and those who advocate totalitarian-cyborg control “management” of “inherent chaotic instability” on the grand-aggregate scale.These aspirations are simply the up-dated heirs of the most extreme LEVELERS and DIGGERS, going back to Gerald Winstanley in the 1600s through their Marxian and Leninist amplifiers. And Dare we even mention the “funny-money” chaps, like Major Douglas, the otherwise great scientist,Frederick Soddy & the “Technocracy”-energy-unit dispensers of the 1930s ?And their contemporary heirs, the QE money machine printers who are quite indebted to them ?
    If we truly want to break-out of these rancid cul-de-sacs, we must enter the universe of another and somewhat scary paradigm. Where much of our world is not very controllable by even the most sanctimonious or “scientistic” claimants to virtue and salvationist intent.
    It is the world of time-path dependency, hysteresis of economic behaviour, non-arithmomorphic {Georgescu-Roegen} gestalt-pull, interactive-organic relationships and the power of EMERGENCES as the basic stuff of economic thought. Not to mention varying classes of uncertainty ranging from radical to somewhat reducible to the calculus of probability.
    The most powerful emergences are {1} The Natural Participation Rate {2} The Current Conception of the Standard of Life and {3} Technological Time. These concepts may not be to everybody’s liking. But they are the consequences of applying “Hume’s Guillotine” to its final destination. Sorry about that folks. Thank you for your patience.
    GOOGLE {1} Norman L. Roth {2}Norman L. Roth, economist {3} Norman L. Roth, Technological Time {4} ,Norman L. Roth, Current Conception of the Standard of Life

  8. Norman L. Roth,
    August 25, 2016 at 7:27 pm

    August 25,2016

    Addendum to the above.

    A possible fourth important emergence is the distribution of wealth and income at a particular era in Technological Time…Which gives rise to corresponding estimates of the degree of.economic inequality. Or is this, fourth important emergence, a derivative of the first ? i.e…. the natural Participation rate ?
    In any case, especially this last emergence, we can see how the suggestion that emergences are the result of evolving, natural, interactive human drives, can, in themselves, be a trigger for convulsive political and emotional indignation; And centuries of outraged violence and polemics. However, economic inequality is hardly the only cause among the divisions afflicting Human Kind. It may not even be the most important. Only the most complex and frustrating.
    “When Adam delved and Eve span, Who was then the gentleman” ? Attributed to John Ball, The “mad priest” of Kent, Truly an ideological godfather of Gerald Winstanley.

    Norman L. Roth

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