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2.9.2 Flexibility of nominal wages

Many orthodox Keynesians place money wage rigidity at the centre of Keynes’s

explanation of involuntary unemployment in The General Theory (see

Modigliani, 1944, 2003; Snowdon and Vane, 1999b; Snowdon, 2004a). Keynes

demonstrated in the General Theory that the way in which nominal wage cuts

would cure unemployment would operate primarily through their impact on

the interest rate. If wage cuts allowed further reductions of the price level,

this would increase the real value of the money supply, lower interest rates

and stimulate investment spending. In terms of Figure 2.6, panel (b), the

falling money wage shifts the aggregate supply curve from W0AS to W1AS

(where W1 < W0). The economy would return to full employment at e2. The

price mechanism has allowed aggregate demand to increase without government

intervention in the form of an aggregate demand stimulus. However, as

we will see more clearly in Chapter 3, section 3.4.2, Keynes introduced two

reasons why this ‘Keynes effect’ might fail. The existence of a liquidity trap

which prevents the interest rate from falling or an interest-inelastic investment

schedule could prevent falling prices from stimulating aggregate demand

via changes in the interest rate. In terms of Figure 2.6, panel (b), these

possible limitations of deflation as a route to recovery would show up as an

AD curve which becomes vertical below e1; that is, the economy is prevented

from moving from e1 to e2.

For Keynes the policy of allowing money wages to fall for a given money

supply could, in theory, produce the same effects as a policy of expanding the

money supply with a given nominal wage. But since this was the case,

monetary policy was subject to the same limitations as wage cutting as a

method of securing full employment. However, a severe deflation of prices

would also be likely to have adverse repercussions on business expectations,

which could lead to further declines of aggregate demand (see Keynes, 1936,

p. 269). The impact of severe deflation on the propensity to consume via

distributional effects was also likely to be ‘adverse’ (Keynes, 1936, p. 262).

In summing up these issues, Keynes took a pragmatic stance.

Having regard to human nature and our institutions, it can only be a foolish person

who would prefer a flexible wage policy to a flexible money policy … to suppose

that a flexible wage policy is a right and proper adjunct of a system which on the

whole is one of laissez-faire, is the opposite of the truth. (Keynes, 1936, pp. 268–

9; see also Modigliani, 2003)

Because of these various limitations of the price mechanism, Keynes was

convinced that the authorities would need to take positive action in order to

eliminate involuntary unemployment. Unless they did so the system could

find itself caught in a situation of underemployment equilibrium, by which he

meant the tendency of market economies to remain in a chronic condition of

subnormal activity for a considerable period ‘without any marked tendency

either towards recovery or towards complete collapse’ (Keynes, 1936, p. 249).