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2.9.1 Rigidity of nominal wages

In the General Theory, to begin with, Keynes assumes that the money wage is

‘constant’ in order to ‘facilitate the exposition’ while noting that the ‘essential

character of the argument is precisely the same whether or not money-wages

are liable to change’ (Keynes, 1936, p. 27). We can see the impact of a

negative demand shock on real output and employment in the case of nominal

wage rigidity by referring to Figure 2.6. Suppose an economy which is

initially in equilibrium at full employment (Le and YF) experiences a fall in

aggregate demand illustrated by a shift of the AD curve from AD0 to AD1. If

prices are flexible but nominal wages are rigid, the economy moves from e0

to e1 in panel (b). With nominal wage rigidity the aggregate supply curve

becomes W0AS. With a fall in the price level to P1, and nominal wages

remaining at W0, the real wage increases to W0/P1 in panel (a). At this real

wage the supply of labour (Ld) exceeds the demand for labour (Lc) and

involuntary unemployment of cd emerges.

According to Keynes (1936, p. 15) workers are involuntarily unemployed

if ‘in the event of a small rise in the price of wage-goods relatively to the

money-wage, both the aggregate supply of labour willing to work for the

current money-wage and the aggregate demand for it at that wage would be

greater than the existing volume of employment’. This makes sense when we

remember that the labour supply curve indicates the maximum amount of

labour supplied at each real wage. Since Le – Lc part of the involuntarily

unemployed workers are prepared to work for the equilibrium real wage W0/

P0 a fall in the real wage from W0/P1 to W0 /P0 is acceptable to them since

they would have been prepared to work for a lower real wage, as indicated by

the supply curve for labour between b and e. A fall in the real wage will also

induce profit-maximizing firms to demand more labour.

But how can the real wage be reduced? There are basically two ways.

Either money wages must fall relative to the price level, or the price level

must rise relative to the nominal wage. Keynes favoured the latter, and

advocated expansions of aggregate demand in order to exert upward pressure

on the price level. In terms of Figure 2.6, panel (b), policies are required

which will shift AD from AD1 to AD0. The rise in the price level from P1 to P0

reduces the real wage back to its equilibrium level of W0/P0 and involuntary

unemployment is eliminated. Keynes rejected the alternative policy of wage

cutting as a method of stimulating employment on both practical and theoretical

grounds. The practical reason was that in a democracy characterized

by decentralized wage bargaining wage reductions are only likely to occur

after ‘wasteful and disastrous struggles’, producing an end result which is not

justifiable on any criterion of social justice or economic expediency (see

Chapters 3 and 19 of the General Theory). Keynes also argued that workers

will not resist real wage reductions brought about by an increase in the

general price level, since this will leave relative real wages unchanged and

this is a major concern of workers. We should note that this does not imply

money illusion on the part of workers. The resistance to money wage cuts and

acceptance of reductions in the real wage via a general rise in the cost of

living has the advantage of preserving the existing structure of relativities

(see Trevithick, 1975; Keynes, 1936, p. 14). In any case, since labour can

only bargain over money wages and the price level is outside their control,

there is no way in which labour as a whole can reduce its real wage by

revising money wage bargains with entrepreneurs (Keynes, 1936, p. 13). But

Keynes went further in his objections to nominal wage cutting than these

practical issues. He rejected wage and price flexibility as a reliable method of

restoring equilibrium on theoretical grounds also. Indeed, in many circumstances

extreme flexibility of the nominal wage in a monetary economy

would in all probability make the situation worse.

Figure 2.6 Keynes and involuntary unemployment