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3 4.1 The general case

Within the IS–LM model the existence of underemployment equilibrium can

be attributed to the existence of ‘rigidities’ in the system, especially two key

prices, the money wage and the interest rate. We begin with that of the

‘Keynesian’ assumption of downward rigidity in money wages. This case can

be illustrated using the four-quadrant diagram of Figure 3.6. Quadrant (a)

depicts the standard IS–LM model. Quadrant (c) shows the short-run production

function where, with the capital stock and technology taken as given, the

level of output/income (Y) depends on the level of employment (L) – see

Chapter 2, section 2.3. Quadrant (d) depicts the labour market in which it is

assumed that the demand for/supply of labour is negatively/positively related

to real wages (W/P). Finally, quadrant (b) shows, via a 45° line, equality

between the two axes, both of which depict income. The inclusion of this

quadrant allows us to see more easily the implications of a particular equilibrium

level of income, established in the goods and money markets in quadrant

(a), for the level of employment shown in quadrant (d). In other words, in

what follows the reader should always start in quadrant (a) and move in an

anti-clockwise direction to trace the implications of the level of income

(determined by aggregate demand) in terms of the level of employment in

quadrant (d).

Suppose the economy is initially at point E0, that is, the intersection of LM0

and IS in quadrant (a). While both the goods and money markets are in

equilibrium, the income level of Y0 is below the full employment income

level YF. Reference to quadrant (d) reveals that with a fixed money wage (set

exogenously) and a price level consistent with equilibrium in the money

market (that is, the curve LM0), the resultant level of real wages (W/P)0 is

inconsistent with the labour market clearing. In other words there is no

guarantee that the demand-determined level of employment (L0) will be at

full employment (LF). The excess supply of labour has no effect on the

money wage, so that it is possible for the economy to remain at less than full

employment equilibrium with persistent unemployment. We now consider

what effect combining the IS–LM model with the classical assumption of

flexible prices and money wages has on the theoretical possibility of underemployment


Figure 3.6 The general case with the Keynes effect

Again suppose the economy is initially at point E0, that is, the intersection

of IS and LM0 in quadrant (a). As before, while both the goods and money

markets are in equilibrium, the income level of Y0 is below the full employment

income level YF. Reference to quadrant (d) reveals that this implies that

the level of employment (L0) is below its full employment level (LF) with real

wages (W/P)0 above their market-clearing level (W/P)1. As long as prices and

money wages are perfectly flexible, the macroeconomy will, however, selfequilibrate

at full employment. At (W/P)0 the excess supply of labour results

in a fall in money wages (W), which reduces firms’ costs and causes a fall in

prices (P). The fall in prices increases the real value of the money supply,

causing the LM curve to shift downwards to the right. Excess real balances

are channelled into the bond market where bond prices are bid up and the rate

of interest is bid down. The resultant fall in the rate of interest in turn

stimulates investment expenditure, increasing the level of aggregate demand

and therefore output and employment. The ‘indirect’ effect of falling money

wages and prices which stimulates spending via the interest rate is referred to

as the ‘Keynes effect’. The increase in aggregate demand moderates the rate

of fall in prices so that as money wages fall at a faster rate than prices (an

unbalanced deflation), the real wage falls towards its (full employment) market-

clearing level, that is (W/P)1 in quadrant (d). Money wages and prices

will continue to be bid down and the LM curve will continue to shift downwards

to the right until full employment is restored and the excess supply of

labour is eliminated. This occurs at point E1, the intersection of LM1 and IS. It

is important to stress that it is the increase in aggregate demand, via the

Keynes effect, which ensures that the economy returns to full employment.

Within this general framework there are, however, two limiting or special

cases where, despite perfect money wage and price flexibility, the economy

will fail to self-equilibrate at full employment. The two special cases of (i)

the liquidity trap and (ii) that where investment expenditure is interest-inelastic

are illustrated in Figures 3.7 and 3.8, respectively.