Keynes and the Classics Part 7

I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text during 2013 (to be ready in draft form for second semester teaching). Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.

I am currently working on Chapter 11 which opens like this:

Chapter 11

11.1 Introduction and Aims

In Chapter 10, we discussed issues relating to labour market measurement. In this Chapter we will focus on theoretical concepts that underpin the measurement of economic activity in the labour market and the broader economy.

The Chapter has five main aims:

• To explain why mass unemployment arises and how it can be resolved.
• To develop the concept of full employment.
• To consider the relationship between unemployment and inflation – the so-called Phillips Curve.
• To develop a buffer stock framework for macroeconomic management (full employment and price stability) and compare and contrast the use of unemployment and employment as buffer stocks in this context.
• To more fully explore the concept of a Job Guarantee (employment buffer stock) approach to macroeconomic management.

NOTE:
The Keynes and Classics series so far is:

• Keynes and the Classics – Part 1 – explains how the Classical system conceived of labour supply and demand and how these come together to define the equilibrium level of the real wage and employment.
• Keynes and the Classics – Part 2 – explains how the labour market determines the level of employment and real wage, which in turn, via the production function set the real level of output.
• Keynes and the Classics – Part 3 – tied the previous conceptual development into the denial that there could be aggregate demand failures (Say’s Law), introduced the loanable funds market and discussed the pre-Keynesian critique (Marx) of the Classical full employment model.
• Keynes and the Classics – Part 4 – which began Keynes’ critique of Classical employment theory.
• Keynes and the Classics – Part 5 – continues the critique of Classical employment theory.
• Keynes and the Classics Part 6 – considers Keynes’ critique of the Classical Theory of Interest.

Today, we finish the critique by John Maynard Keynes of the Classical labour market.

NEW TEXT STARTS TODAY HERE

11.16 The macroeconomic demand curve for labour

The interdependency of aggregate supply and demand

While Keynes’ critique of Classical employment theory was focused mostly on showing that the Classical labour supply construction was deeply flawed, his ideas on the impact of money wage changes on effective demand allows us to derive a consistent aggregate demand curve for labour, which replaces the marginal productivity theory and shows how effective demand determines employment.

Recall that the Classical employment theory considered unemployment (beyond frictional levels) to be the result of the real wage being higher than the equilibrium level, which was tied to a unique level of productivity that would occur if labour demand was equal to labour supply.

The major result from that theory is that flexibility of money wages (and hence real wages) will continuously clear the labour market and maintain full employment.

In this approach, given that profit-maximising firms are assumed to be constrained by diminishing marginal productivity of labour, they will only employ more workers if the real wage falls because each additional worker hired is less productive than the last and profit maximisation requires that the real wage (the output cost of the additional unit of labour) be equated with the marginal product (the contribution to output of the last unit of labour).

If we think about this in terms of the production of real goods and services, each additional unit of labour adds to production but is assumed to add less than the previous unit(s) employed. When money wages fall the marginal cost of production fall (assuming productivity is constant) and the firm’s output supply curve shifts out – that is, they are prepared to supply more at each price level because their unit costs are lower.

The Classical theory considered the aggregate supply curve (relating the prices that are sought at each supply level) to be the sum of the industry supply curves, which, in turn, were considered to be aggregates of the firm supply curves. As a result, when money wages fell the supply curves of firms, the industry and all industries shift outwards.

In – Chapter Changes in Money Wages – of his , Keynes wrote (page 259 CHECK):

The argument simply is that a reduction in money-wages will cet. par. stimulate demand by diminishing the price of the finished product, and will therefore increase output and employment up to the point where the reduction which labour has agreed to accept in its money-wages is just offset by the diminishing marginal efficiency of labour as output (from a given equipment) is increased.

Keynes realised that this reasoning was flawed at the most elemental level. For it assumes that the aggregate supply curve (the sum of all the firm supply curves) shifts out as money wages fall and traces out a path along a fixed aggregate demand curve. That is, output increases.

Keynes said (page 259):

In its crudest form, this is tantamount to assuming that the reduction in money-wages will leave demand unaffected.

In other words, the Classical theory assumed that the aggregate supply and aggregate demand curves were independent of each other and when the aggregate supply curve shifted out the aggregate demand curve was unchanged.

Hence, the money wage cut leads to an expansion of output because firms are prepared to hire more workers an to supply more output at the given price level.

Keynes wrote (page 259) that:

… whilst no one would wish to deny the proposition that a reduction in money-wages accompanied by the same ggregate effective demand as before will be associated with an increase in employment, 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.

Once again this is an example where specific to general reasoning provides the wrong answer. What might apply at the single firm or even industry level does not necessarily apply at the aggregate level. That is the basis of the fallacy of composition, which we explained in the context of the Paradox of Thrift in Chapter 7.

At the specific or individual firm level, the firm’s output supply curve might shift out (meaning it will be prepared to supply more output at each price level) after it cuts the money wage of its workers. The firm could expect no shift in the demand for its product as a result of the money wage cut. The lower wages now paid to the firm’s workers will lower its unit costs (and push its supply out) but would not be significant enough, in the economy-wide context, to influence the demand for the firm’s output.

Keynes was prepared to accept that logic (page 259):

It is indeed not unlikely that the individual entrepreneur, seeing his own costs reduced, will overlook at the outset the repercussions on the demand for his product and will act on the assumption that he will be able to sell at a profit a larger output than before.

But what if all firm’s cut money wages? The Classical theory of employment focused on only one aspect of money wages – that they were a cost of production and influenced the supply-side of th economy. However, Keynes noted that money wages were also a significant component of a worker’s income and by aggregation, national income.

Given that consumption spending was directly tied to national income and investment spending was also likely to fall, if consumption spending fell, Keynes argued that the demand curves (at the firm, industry and aggregate) level would shift inwards (spending at each price level would be lower) after a money wage cut.

While firms might enjoy lower unit costs they also faced a declining demand for their goods, in general, because the lost income resulting from an economy-wide money wage cut would be significant.

This insight means that the output demand and supply curves are interdependent. A shift in the supply curve out resulting from a money-wage cut will also manifest as a shift in the demand curve inwards. This interdependency also negates the Classical construction of the aggregate marginal productivity curve being the macroeconomic demand curve for labour.

In the Classical employment theory, a money wage cut (indicating that the labour supply curve has shifted out because workers in aggregate will not supply more hours of work at each money wage level) leads to a movement along a fixed marginal productivity curve. However, once we recognise the interdependency between the the demand and supply sides, it is clear that the marginal product curve loses its capacity to describe what will happen to employment.

The overall impact on employment of a money wage cut (or rise) will depend on the relative magnitudes of the supply and demand shifts.

In the case of a money wage cut, for example, if the aggregate supply curve shifts out and the aggregate demand curve shifts in, then it is possible that employment rises, does not change or declines. The marginal productivity demand curve for labour only permits the first option and therefore cannot be a general macroeconomic demand curve for labour.

Money wage changes and shifts in effective demand

The clue to deriving a macroeconomic labour demand curve is to analyse the impact of money wage changes on effective demand, which means we consider the relative magnitudes of the shifts in aggregate supply and aggregate demand, as outlined in Chapters 5, 6 and 7.

Recall from Chapter 7, we noted that the point of nominal effective demand is found at the intersection of the aggregate demand (D) and aggregate supply price (Z) curves. We learned that the point of effective demand occurs where all individual firms are maximising expected profits.

Keynes defined the aggregate supply price of the output derived for a given amount employment as the “expectation of proceeds which will just make it worth the while of the entrepreneur to give that employment” (footnote to Keynes, J.M. (1936) The General Theory of Employment, Interest and Money, Macmillan, page 24 – check page).

We learned that this concept related a volume of revenue received from the sale of goods and services to each possible level of employment. At each point on the aggregate supply price curve, the revenue received would be sufficient to cover all production costs and desired profits at the relevant employment level.

The other way of thinking about the aggregate supply price Z-function is to express it as the total amount of employment that all the firms would offer for each expected receipt of sales revenue from the production that the employment would generate.

Firms build a stock of productive capital through investment in order to produce goods and services to satisfy demand. Once the capital stock in in place, firms will respond to increases in spending for the goods and services they supply by increasing output up to the productive limits of their capital and the available labour and other inputs. Beyond full capacity, they can only increase prices when increased spending occurs.

Aggregate demand is the total purchases by households, firms, government and foreigners (rest of the world) on goods and services produced by domestic and foreign firms. The volume of real output supplied to the economy is determined by aggregate demand subject to there being idle productive capacity.

From our earlier discussion, the money wage impacts on both the supply- and demand-sides of economy. The balance between demand and supply – the point of effective demand – thus depends on the magnitude of the money wage. This, in turn, sets the level of employment that firms will offer.

In other words, we can draw a family of D and Z curves (and points of effective demand) corresponding to different money wage levels. Figure 11.11 shows one such family of curves, drawn upon the assumption that the impact on aggregate demand (D) of a money wage cut is greater than the impact on aggregate supply (Z).

If the money wage rate was W₀, the D-curve would be at D(W₀) and the Z Curve would be at Z(W₀), establishing a point of effective demand at E₀