Keynes’ Expertise Guide to Wage Rates of Unemployment

This article provides Keynes’ expertise guide to wage rates of unemployment.

Keynes vehemently opposed the classical position of automatic adjustment and the Pigovian formulation of Say’s Law because the same had become obsolete in the conditions of contemporary capitalist world.

Keynes particularly objected to the notion that unemployment would disappear, if workers will just accept sufficiently low money wage rates.

According to Keynes’ this type of classical reasoning turned out to be extremely disastrous both from the theoretical and practical points of views.

He contended that collective bargaining by trade unions, minimum wage laws, unemployment benefits, etc. have become an integral part of the modern advanced and democratic economists possessing increased productivity and technology and the classical theory of employment though quite logical on account of strong basic postulates yet is unacceptable owing to the unrealistic nature of its assumptions.

Although Keynes agreed with the first classical postulate that given the volume of employment (and assuming a given state of organization, technique and equipment) the marginal product and the real wages are uniquely determined, he did not agree with the second postulate of the classicals that the existing real wage is equal to the marginal disutility of employment.

He argued that if the utility of the current real wage rate is exactly equal to the marginal disutility of labour it would be impossible to raise the level of employment by increasing aggregate demand. If the workers insist that every rise in general level of prices (resorted to in order to increase aggregate demand) must be, simultaneously, followed by rise in money wages, then, the only effect of increasing aggregate demand would be price inflation with little or no increase in employment.

In Keynes’ view, the existing real wage is not always equal to the marginal disutility of labour and, therefore, the labour may well be prepared to accept additional employment at current money wage even though this may mean lower real wage. Thus, according to Keynes the manipulation of demand, and not wage rate, is far more effective way to increase employment.

There is, however, a problem in Keynesian solution. If a fall in wages and prices fails to reduce the level of unemployment, why will wages and prices not continue to fall indefinitely? This is exactly what does not happen; money wages, as already pointed out, tend to be sticky in the downward direction.

In an environment of trade unionism workers can protect themselves against wage cuts. A previously hard won wage increase tends to be maintained despite sinking employment. Keynes, instead of assuming that the supply of labour depends on the real wage, assumed that the labour is subject to money illusion and that the supply of labour is a function of the money wage rate as shown in Fig. 23.1.

In this figure W₀ is the historically given money wage rate and P₀ is the ruling price level. At money wage W₀ workers will offer anywhere between zero and N₁ units of labour. Thus, the labour supply curve is a horizontal line at W₀/P₀. Although, the money wage rate cannot be made to fall, it will rise when all those who are willing to work at W₀ are employed and additional workers are desired. Consequently, the labour supply curve bends up sharply once N₁ has been reached. In the figure the labour demand schedule cuts the supply schedule at N₀; as a result, the distance between N₁—N₀ measures involuntary unemployment—the number of workers willing to work at existing level of real wages but does not find employment.

Since the money wage rate is assumed to be downwardly rigid (and since a fall in wages, even if it could be brought about, would result in proportional fall in prices), the restoration of full employment can come about only through a fall in real wages; resulting from an increase in aggregate demand and the price level.

If such a rise in the price level comes about, the entire labour supply schedule shifts down, and involuntary unemployment is eliminated. Thus, at real wage W₀/P₁ the labour demand schedule cuts the supply schedule at N₁, where all who are willing to work at new real wage are employed. Let us note that even though the real wage has fallen, the number of workers willing to work at the new real wage is the same as at the old real wage—a result that follows from the assumption of money illusion.

Now, let us consider Pigovian equation within the Keynesian framework along with the diagrammatic explanation. Pigovian equation is N = q Y/w in which N indicates employment, q is that part of national income Y which goes to workers in the form of wages, Y is national income or total money income (wages and non-wages), W is the money wage rate. Therefore, NW = qY is an arithmetical truism.

Applying Keynesian analysis to Pigovian equation, the net result is that if W is lowered, then Y will also fall more or less in the same proportion having little or no effect on N, unless q also changes (i.e., there is or may he substitution of labour for other factors in view of the fall in money wages).

Representing diagrammatically the position is as follows:

(a) N indicates employment and is measured on the horizontal axis, and W the wages rate on the vertical axis. DL₁is the demand function for labour, showing the functional relation of N to W i.e., how much employment is given at a certain wage rate.

(b) When the wage is OW₁ employment is ON_p and the demand for labour is denoted by DL₁ at aggregate demand income Y₁.

(c) Now, when the wage rate is cut to OW₂, it leads to a proportionate drop in demand for labour denoted by DL₂ as a result of a drop in aggregate demand income to Y₂ leaving N unchanged at N_p. Thus, it is clear that the demand function for labour will shift up and down as the aggregate demand (Y) rises or falls. But this assumes that a change in W causes a proportionate change in Y leaving q unaffected. What will actually happen is not easy to foresee.

However, Keynes Money Wage Theory is based on certain assumptions that:

(i) That labour is the only variable factor of production,

(ii) That pure competition exists throughout the economy,

(iii) That ‘money illusion’ affects the supply function for labour,

(iv) That ‘money illusion’ does not occur in other supply and demand functions.

Keynes again made an attempt to analyse the problem of the effects of wage cuts on aggregate demand and employment in greater details and he found no simple answer to this problem. Whether aggregate demand will fall proportionately with a fall in money wage is not easy to analyse and depends partly on what happens to non-wage groups. Keynes himself says, “The consequences of a change in money wages are complicated.” He wished to know whether wage reductions will change the principal determinants of employment—the propensity to consume, schedule of the marginal efficiency of capital, and the rate of interest.

It is argued that the underemployment equilibrium of Keynes is the result of his assumption that wages are rigid in the downward direction. Classicals, on the other hand, assert that if wages are allowed to be flexible in the downward direction, equilibrium of the economy with less than full employment (or underemployment equilibrium) would be out of question. It was against such a view that Keynes led a frontal attack.

According to him the basic law in the classical reasoning is that when there is general reduction in wages, the aggregate volume of effective demand remains unaltered. Keynes, no doubt, admitted that a fall in wages and prices has, under certain conditions, monetary consequences, similar to an increase in the quantity of money. He also realised that a reduction in money wages is quite capable, under certain conditions, of affording a stimulus to output as in the case of a particular firm or industry but to apply this to the economy as a whole would be a grave mistake.

To Keynes, “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”. His difference from the classicals, therefore, is primarily a difference of analysis.

Broadly speaking, modern economists like Prof. Hansen consider Keynes’ theory of employment and wages based on effective demand as modern theory of employment and wages. According to them there is no basic or vital difference between Keynes’ and modern theory of employment and wages, the difference is of degree only and not one of kind. Modern economists do not agree to one essential part of his analysis and to that extent, they may be said to have modified or improved Keynesian theory of employment and wages.

Keynes believed that a rise in employment through a rise in effective demand means lower real wages because of the rise in prices due to monetary expansion, as a result of cheap money policy advocated by him. But modern theory of employment and wages does not agree to it, as it believes that there is no inverse relationship between wages and employment and it is possible to increase employment without, at the same time, lowering the real rates or standard of living of the workers.

Modern theory offers a more optimistic view of the possibilities of expanding employment through raising aggregate demand without raising prices more than the increase in output and employment. Except for this, modern economists support, to all intents and purposes, the aggregate effective demand theory of Keynes to increase employment.