Keynes and NKE

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Wage Behaviour and Unemployment in

Keyness and New Keynesians Views.

A Comparison

Nicola Meccheri

Revised version: December 6, 2005

Dipartimento di Scienze Economiche, Facolta di Economia, Universita di Pisa. ViaC. Ridolfi 10, I-56124 Pisa, Italy. Tel.: ++39 050 2216377,fax: ++39 050 598040, e-mail:

[email protected]

Special thanks are due to Carlo Casarosa, Geoffrey Harcourt, Neri Salvadori, Maurizio

Zenezini and two anonymous referees for their thoughtful and extensive comments and

suggestions. I would like to thank also Davide Fiaschi, Francesco Filippi, Mario Morroni

and Carlo Panico for their comments on a previous draft. Of course, all errors remain my

own.

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Abstract

The paper compares different strands of New Keynesian Economics

with respect to Keyness original work. In particular, two issues are

analysed in detail. First, the explanations provided by Keynes and

New Keynesians of nominal and real wage behaviour. Second, the

different theories and interpretations concerning the ability of flexi-

ble nominal wages in assuring full employment. It is argued that,

although persistent involuntary unemployment is a central problem

both in Keyness and New Keynesians views, referring to the role of

nominal and real wages in explaining unemployment, New Keynesians

theories present important features which differ, sometimes substan-

tially, from the concepts developed by Keynes in his General Theory.

In this direction, hopefully, further clarifications of the issues involved

are presented.

Keywords: Keynes, New Keynesian Economics, Nominal Wages,

Real Wages, Unemployment

JEL codes: B20, B40, E12, E24

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1 Introduction

Introducing the New Keynesian Economics (NKE) symposium in the Journal

of Economic Perspectives in 1993, Gregory Mankiw, a leading New Keyne-

sian economist, stated that like Keynes, new Keynesians begin with the

premise that persistent unemployment and economic fluctuations are central

and continuing problems and that traditional expositions of Keynesian

economics emphasized the role of rigidities in nominal wages and prices

(Mankiw 1993, pp.3-4). New Keynesians also argued that in traditional

Keynesian economics crucial nominal rigidities were assumed rather than

explained (Ball, Mankiw and Romer 1988, p.2). Thus one of the most

important contributions of NKE to Keyness original work has often been

associated with the improvements obtained in providing acceptable micro-

foundations for the phenomena of wages and prices sluggish adjustments.1

Nevertheless, this interpretation may be strongly misleading if it conveys the

impression that Keynes considered rigidities as being somehow responsible

for his most important results.2

This paper aims at comparing different strands of NKE with respect to

Keyness original work on wages, pointing out the real contributions of the

NKE and describing the major differences and analogies between the master

and his descendants. In particular, two issues will be analysed in detail.

1This result is clearly stated also by two other prominent New Keynesian economists

when they argue that The New Keynesian Economics [...] succeeds both in filling the

lacunae in traditional Keynesian theory (e.g. by explaining partial wage rigidities, rather

than simply assuming rigid wages) and resolving the paradoxes and inconsistencies of moretraditional Keynesian theory ... (Greenwald and Stiglitz 1987, p.126). While Greenwald

and Stiglitz (1987) provide a broad comparison between the NKE and traditional Keyne-

sian economics focusing mainly on capital markets, in this paper attention is concentrated

on the labour market.2For a broad discussion in the same symposium on the JEP, see Tobin (1993). In

particular, Tobin stressed that the central Keynesian proposition is not nominal price

rigidity but the principle of effective demand (Tobin 1993, p.46).

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First, the explanations provided by Keynes and New Keynesians of nominal

and real wage dynamics. Second, the different theories and interpretations

concerning the role of flexible nominal wages in assuring full employment in

the economy. In these perspectives, the paper, hopefully, presents further

clarification of the issues involved.

One of the most widely discussed issues about Keyness contribution lies

in his explanation for a possible source of downward nominal wage stickiness.

This explanation has become the target of numerous unfair attacks and it

has been criticised as being based on irrational behaviour by workers. Suchcriticism is groundless since the explanation provided by Keynes is theoreti-

cally valid besides being confirmed by empirical observations. Nevertheless,

some other points in Keyness analysis concerning wage dynamics should be

more deeply explored and in this direction NKE has been effectively able to

provide its own contribution.

Concerning the capacity of nominal wage reductions in restoring full em-

ployment, it is well known that Keynes did not believe that nominal wage

rigidity was the main source of unemployment and, as a consequence, that

nominal wage cuts were not the proper cure for it, and might not be a cure at

all. In this perspective, the strand of NKE which focuses on nominal wages

and price rigidities seems to be in contrast with Keyness view since, in such

a New Keynesian framework, flexible wages and prices would allow the econ-

omy to maintain full employment. On the other hand, as will be discussed

below, other New Keynesian theories, albeit with some major distinguishing

features, seem to reinforce Keyness conclusion.

It is important to clarify here the boundaries of this paper. Theories

labelled as Keynesian are extremely various and different as well as the in-

terpretations given to Keyness original work by his successors (e.g. Patinkin

1990). As already indicated, the paper aims at comparing in detail Keyness

ideas, as propounded mainly in The General Theory, with the New Key-

nesian models that have been developed since the end of 1970s in order to

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provide more solid micro-foundations for the phenomena of wage and price

rigidity. By contrast, other important theories which commonly belong to the

Keynesian tradition, such as the famous Neoclassical Synthesis (e.g. Hicks

1937; Modigliani 1944), the fixed prices or general disequilibrium models

(e.g. Clower 1965; Malinvaud 1977), and the Post-Keynesian school (e.g.

Robinson 1973; Chick 1983), are not considered, except only incidentally, in

this paper. This choice of focus in the paper also explains why the analysis

that follows concentrates on the short run (given technology) and on a closed

economy. This is because, to the best of my knowledge, the Keynes versusNKE debate on wage rigidity and unemployment has advanced over the last

two decades mainly in such a framework.

The rest of the paper is structured as follows. Section 2 describes Keyness

analysis of nominal and real wages behaviour and presents some New Key-

nesian contributions, emphasising major differences and similarities with

Keyness original work. Given its particular relevance, the issue of differ-

ences about Keyness and alternative New Keynesians views concerning the

ability of nominal wage flexibility in restoring full employment is separately

analysed and deferred until Section 3. Finally, these observations are drawn

together in the concluding Section 4.

2 Nominal and Real Wage Dynamics

2.1 The General Theory of John Maynard Keynes

At the beginning of The General Theory (GT, Ch.2) Keynes assumed that

the nominal wage was constant in order to facilitate the exposition of his

argument but he clarified that the essential character of the argument is

precisely the same whether or not money-wages [...] are liable to change

(GT, p.27). Keynes presumed that nominal wages were as a rule a function

of activity, tending to rise and fall with the level of output and employment.

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Concerning the relationship between nominal and real wages, Keynes argued

that:

It would be interesting to see the results of a statistical enquiry into

the actual relationship between changes in money wages and changes

in real wages. [...] But in the case of changes in the general level

of wages, it will be found, I think, that the change in real wages,

is almost always in the opposite direction. When money-wages are

rising, that is to say, it will be found that real wages are falling; and

when money-wages are falling, real wages are rising. (GT, p.10).

In a subsequent article (Keynes 1939) related to the debate on relative

movements of real wages and output (which shall be discussed below), Keynes

pointed out that in order to correctly understand the passage ofThe General

Theory quoted above, it is important to distinguish between two different

situations.

On the one side, we have the case in which the reaction of wages is due to

changes in output and employment driven by changes in effective demand.

In such a case, to which the passage above refers, Keynes maintained that

rising nominal wages and falling real wages are likely to accompany increasing

output and employment; the opposite when output and employment are

decreasing.3

On the other side, there is the case in which changes in nominal wages are

not caused by changes in effective demand but, for instance, by changes in the

conditions governing wage bargaining.4

In this second perspective, Keynes3This implies that prices increase (decrease) more than wages when output increases

(decreases). In Keyness view this happens because there is a prevalence of increasing

costs in the short term of the upswing and a rise in the proportion of product going to

profits during expansion, while the reverse patterns of change characterise contractions in

output (see the letter from Keynes to Dunlop dated 1938 (Dunlop 1998, Appendix)).4Keynes specified that, in such a case, variations in nominal wages are not caused by

changes in effective demand but they may cause such changes (see Section 3 on this point).

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argued that if a nominal wage reduction were to occur, real wages would

be unlikely to be reduced as neoclassical economists predicted. Considering

the economy as a whole, a nominal wage reduction that is not followed by

a price decrease implies a fallacy of composition. In this scenario, nominal

wage reductions would not tend to reduce unemployment, since the level of

real wages could remain largely unaffected.5 More in general, nominal wage

changes can produce complex effects on output and employment which are

difficult to generalise.

Keynes also provided a reason for the observation of downward wagestickiness in the presence of excess supply of labour, in the circumstances of

British industrial relations between the two World Wars, which has been the

focus of discussion and criticism. In Keyness view, workers are concerned

not only with real wages but also with relative wages, that is with how their

pay compares with the pay of those to whom they regard themselves at least

equal in merit and status. However, if labour markets are disaggregated and

desynchronised, a nominal wage cut for a single worker or a group of workers

appears as a reduction in relative wage, since there is no guarantee that

other workers or groups of workers elsewhere receive the same cut. Hence, in

an economy characterised by decentralised wage bargaining, wage reductions

are only likely to occur by producing a final result which is justifiable on no

criterion of social justice or economic expediency (GT, p.267).

Summing up, Keynes explained the possibility of nominal wage downward

rigidity (at least over a certain range) in the presence of involuntary unem-

ployment with workers concerns about their relative wages. He postulated,

on the other hand, that, for a given technology, a rise in effective demand

would produce a fall in the real wage via an increase in the general level of

5Hicks linked this event to what he termed Keyness wage theorem. In particular,

When there is a general (proportional) rise [decrease] in money wages, says the theorem,

the normal effect is that all prices rise [decrease] in the same proportion whence the rate

of interest will be unchanged (Hicks 1974, p.59, italics in original). (I am grateful to an

anonymous referee for reminding me of the passage quoted above.)

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prices. This asymmetry led many critics to wonder why workers would accept

a cut in real wages effected by an increase in prices but resist reductions in

nominal wages, concluding erroneously that Keynes was attributing money

illusion to workers (e.g. Leontief 1936).

In fact, from the theoretical viewpoint, the resistance to nominal wage

cuts and acceptance of reductions in real wages via a general rise in cost of

living is perfectly consistent with the goal of preserving the existing structure

of relative wages in disaggregated and desynchronised labour markets. Thus

workers are not behaving irrationally and no money illusion phenomenon isimplied in Keyness argument (e.g. Trevithick 1992, pp.109-11). Moreover,

most recent findings on changes in pay over time also lend empirical support

to Keyness statement, since, although nominal wages are not completely

rigid downwards, they are somewhat sticky in the short term and are certainly

not all adjusted instantaneously to labour market changes; on the other hand,

real wages decreases are not rare (e.g. Blinder and Choi 1990; McLaughlin

1994; Card and Hyslop 1997). Of course, there could also be reasons other

than Keyness explanation for which nominal wages are downwardly sticky

and NKE has provided some contribution in this direction that shall be

discussed later. However, Keyness argument surely remains relevant.

A somewhat major problem with The General Theory refers to cyclical

behaviour of real wages. Keynes considered perfect competition in all prod-

uct markets6 but, as previously discussed, nominal wages were not perfectly

flexible. In this scenario, a combination of Marshallian product markets with

price-taking firms and neoclassical production technology as well as sticky

nominal wages imply that aggregate demand contractions during a reces-

sion are associated with a rise in real wages and the reverse patterns of

6Although various reasons have been put forward to explain such a choice, the fact

that Keynes did not think imperfect competition altered his argument in any essential

way appears to be the most relevant. Indeed, Keyness theory of effective demand is

compatible with hypotheses other than perfect competition (e.g. Casarosa 1981; Shapiro

1997).

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change will characterise expansions in aggregate demand and output, that is

real wages move counter-cyclically. Thus, Keynes and the neoclassical tradi-

tion in Cambridge had the same perspective of real wage behaviour during

economic fluctuations.7 In other words, Keynes refuted the second postu-

late of classical economics but accepted the first postulate which classical

economists have (rightly) asserted as indefeasible (GT, p.17).

As Dunlop (1938) and Tarshis (1939) first found, the problem here is

that this result has been repeatedly refuted by empirical observations. In

Dunlops 1938 article, the British experience for the period 1860-1937 wassummarised in the following passage:

Increases in [money] wage rates [during an upswing] have usually

been associated with increased real wage rates, while decreases in wage

rates have equally often been associated with a rise or fall in real wage

rates. (Dunlop 1938, p.421).

An alternative formulation concerning the contraction phase of the busi-

ness cycle stated that real wages rose in an initial phase of the downswing

in some cycles as nominal wages resisted reduction, and then in a second

phase real and nominal wages both declined (Dunlop 1938, p.425). Similar

results were found by Tarshis considering the U.S. experience for 1932-8, and

the current consensus (e.g. Mankiw 1990; Abraham and Haltiwanger 1995)

is that real wages appear to have no consistent relationship with economic

activity, or perhaps appear slightly pro-cyclical.

Indeed, Keynes received this evidence positively (albeit with some caveats)and, in a long reply to Dunlop and Tarshis (Keynes 1939), admitted that in

The General Theory he was accepting, without taking care to check the facts

for himself, a belief which had been widely held by British economists. At the

7However, Pigou in his Industrial Fluctuations reported that the upper halves of trade

cycles have, on the whole, been associated with higher real wages than the lower halves

(Pigou 1927, p.217).

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same time, he specified that, if real wages do not move counter-cyclically, his

practical conclusions would have a fortiori force since it is possible to increase

employment without negatively affecting real wages.

In the same article, Keynes also listed different theoretical reasons for

the observation of a pro-cyclical behaviour of real wages.8 Particularly, if

the economy is in unusually deep recession, firms may be operating at lev-

els of output at which marginal costs are decreasing. However, Keynes was

very cautious in accepting diminishing marginal costs as a general charac-

teristic even if high levels of unemployment would occur in the economy.Another important possible reason outlined by Keynes for real wage non-

countercyclical behaviour concerns the role of non-perfect competition and

sticky prices which were later to receive formal treatment from a strand of

NKE (see below). Nevertheless, in The General Theory a problem in de-

scribing the observed dynamics of real wages during business cycles does

remain.

Indeed this problem could be overcome by simply relaxing the assump-

tion that the capital stock is always fully utilized irrespective of the extent of

unemployment in the labour market. As Patinkin (1965) pointed out, during

a Keynesian recession capacity underutilization is typically observed side by

side with unemployed labour. This opens up the possibility of two alter-

native scenarios in which the counter-cyclical real wage dynamics does not

necessarily hold anymore. First, there could be various downward-sloping

labour demand schedules for different degrees of capacity utilization and a

8In Keynes (1939) it is also remarked that Pigou, and many other classical economists,

maintained that an increase in effective demand, via public investment policies, would

indirectly reduce unemployment by deceiving workers into accepting a lower real wage.

Thus, it was the last that actually caused employment to rise (as a consequence, Pigou

and classical economists argued that the same result would has been more rapidly obtained

from a direct attack on real wages by reducing money wages). Keynes concluded that If

the falling tendency of real wages in periods of rising demand is denied, this [Pigous]

alternative explanation must, of course, fall to the ground. (Keynes 1939, p.40).

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variation of capacity utilization over the cycle moves actual labour demand

schedule from one to another. Keynes, however, explicitly denied that the

labour demand schedule shifts over the business cycle due to fluctuations of

effective demand:

It is difficult to see a reason why [factors affecting the real labour

demand schedule] should change, except gradually over a long period.

Certainly there seems no reason to suppose that they are likely to

fluctuate during a trade cycle. [...] I should expect, therefore, that the

real demand for labour would remain virtually constant throughout a

trade cycle. (GT, p.279).

Thus, if (un)employment changes due to cyclical fluctuations of effective

demand but, as maintained by Keynes, the labour demand schedule cannot

shift because of those fluctuations, there remains a second alternative sce-

nario, namely the decline in effective demand does not only push workers off

their labour supply schedule, but it also pushes firms off their labour demand

schedule.9

In such a case, however, to account for fluctuations and persis-tence in unemployment, it also has to be explained why price adjustments

fail to rapidly absorb those fluctuations and reduce unemployment. This

represents the major point in the NKE.

9Alternatively, the two scenarios, which appear when the fully-utilized capacity hy-

pothesis is relaxed, can be described as follows. In the former, there is, in fact, a family

of marginal productivity curves, one for each level of capacity utilization (see McCombie

(1985) for a systematic treatment), while, in the latter, the marginal productivity prin-

ciple becomes irrelevant in periods of general unemployment and under-utilized capacity

(as is well known, this argument, originally proposed by Patinkin (1965), was later elabo-

rated and refined by the strand of the fixed prices and general disequilibrium models (e.g.

Malinvaud (1977)).

It is also worth noting that both scenarios maintain a Keyness insight abounding an

other. In particular, as specified above, the latter (but not the former) holds that the

labour demand schedule does not shift during the business cycle, while the former (but

not the latter) preserves the first postulate of classical economics since, for a given level

of capacity utilization, the real wage is equal to the marginal productivity of labour.

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2.2 New Keynesian Economics

Turning to analyse the various New Keynesian theories on wage behaviour,

it is convenient to refer to the commonly-used classification, which divides

them into two more comprehensive groups: theories on real wage rigidity

and theories on nominal wage and price rigidity (e.g. Snowdon, Vane and

Wynarczyk (1994, Ch.7)).

New Keynesian theories on real wage rigidity aim to explain mainly the

presence and persistence of involuntary unemployment over time. Indeed,

New Keynesians regard this aspect as one of Keyness most valuable insights

(Greenwald and Stiglitz 1987, pp.120-1), but it is important to stress that

they tackle a somewhat different question than the traditional Keynes issue

concerning insufficient aggregate demand. They explain why, regardless of

the level of aggregate demand, labour markets do not clear at the microeco-

nomic level when there is (involuntary) unemployment. Indeed, in a single

labour market, if unemployed workers offered to work for less pay and firms

were willing to hire them at that lower pay, real wages would be bid down

and, with a standard downward-sloping labour demand schedule, employ-

ment would increase. Since Keynes provided no complete analysis of such an

issue, and as it is not clear whether workers concerns about relative wages

suffice to explain why unemployed workers do not offer to work for lower

pay than that actually paid to those employed10, New Keynesians models on

real wage (downward) rigidity provide their own contribution by introducing

alternative (and more robust) explanations for such a phenomenon.

10Consider this utility function for worker i: uiWi

P, WiWj

, with Wi

Pand Wi

Wjwhich rep-

resent respectively her/his real wage and relative wage compared to a worker j. Assume

also that worker i reservation utility when s/he is unemployed is equal to ui. In this case,

when worker i is unemployed, s/he would not accept a nominal wage Wi

< Wi only if

ui

W

i

P,W

i

Wj

ui. However, if ui

Wi

P, WiWj

> ui there could be a wage W

i

for which

ui

Wi

P, WiWj

> ui

W

i

P,W

i

Wj

> ui. In such a case, why does worker i not accept a (lower)

wage Wi

when s/he is unemployed?

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In detail, efficiency wages and insider-outsider theories explain why firms

do not cut wages when there are unemployed workers. In an asymmetric in-

formation framework, efficiency wage models (e.g. Akerlof and Yellen 1986;

Weiss 1990) describe several reasons why cutting a wage adversely affects the

quality or productivity of labour and increases at the end its cost measured

in terms of efficiency units. The most important versions of this story fo-

cus on the effect on the distribution of workers hired (the adverse selection

effect) and the effect on the performance of individual workers (the incen-

tive or moral hazard effect). In insider-outsider theories (e.g. Lindbeck andSnower 1990), insiders (incumbent workers) have some power in determining,

at least partially, firms wage and employment decisions due to the presence

of turnover costs. Since it is costly for a firm to exchange insiders for out-

siders (unemployed workers), the insiders can extract a share of the economic

rent generated by such turnover costs. Moreover, since in these models real

wages are (downwardly) rigid, economic shocks may have little or no effect

on the wage rate, but simply lead to variations in employment. Thus the

dynamics of real wages may show no systematic correlation with economic

activity, which is consistent with empirical observations.11

Although Greenwald and Stiglitz state that Keynes attributed the per-

sistence of unemployment to the failure of wages to adjust with sufficient

speed to clear labour markets ... [and] efficiency wage [and insider-outsider]

models offer a compelling set of explanations for [this] critical Keynesian

contention ... (Greenwald and Stiglitz 1987, p.121), there are substantial

differences between Keyness own theory and the New Keynesian models out-

11However, some New Keynesian theories on real wage rigidity produce a real wage

dynamics which is too pro-cyclical and have been criticised because, as already discussed,

evidence suggests that the real wage rate is, if not a-cyclical, at worst slightly pro-

cyclical. I refer in particular to the famous shirking version of efficiency wage models,

due to Shapiro and Stiglitz (1984), in which the efficiency wage is sensitive to the rate of

unemployment and lower unemployment rates force firms to pay higher wages as a workers

discipline device (for a reply to such criticism see Stiglitz (1987, pp.36-7)).

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lined above. In fact, both in Keyness and the New Keynesian framework

a decrease in the real wage rate is necessarily linked to an increase in em-

ployment, but the mechanism which underlies this relation differs markedly

in the two frameworks. Keynes, indeed, emphasised that the real wage is

not directly fixed by economic agents through bargaining12 and he asserted

that only a rise in the effective demand would determine, via an increase in

prices, a fall in the real wage rate (together with an increase in output and

employment). Literally, The propensity to consume and the rate of new

investment [i.e. the effective demand] determine between them the volumeof employment, and the volume of employment is uniquely related to a given

level of real wages - not the other way round. (GT, p.30, italics added)13.

Putting it another way, in Keyness view, the real wage rate is rigid only if

the level of effective demand is fixed. By contrast, in New Keynesian theories

of real wage rigidity, such rigidity is due to optimal (equilibrium) choices of

rational firms and workers. Thus policies to reduce the real wage rate must be

directed to modify microeconomic incentives for them (e.g. modifying social

institutions in the labour markets, increasing labour productivity, reducing

insiders power, etc.). On the contrary, these models largely leave unclear

the role (if any) for the aggregate demand. Therefore, while New Keynesian

models of real wage rigidity produce an unemployment equilibrium outcome

12As Trevithick points out, The impotence of the two parties [workers and employers]

to the wage bargain to bring about a reduction in the real wage is what makes Keynesian

unemployment involuntary (Trevithick 1992, p.96, italics in original).13Keynes advanced this idea on many other occasions. For instance, in his memorandum

of 1930 to the committee of economists of the Economic Advisory Council, he assertedthat Real wages seem to me to come in as a by-product of the remedies which we adopt

to restore equilibrium. They come in at the end of the argument rather than at the

beginning and also Employment is not a function of real wages in the sense that a

given degree of employment requires a determinate level of real wages, irrespective of how

the employment is brought about [Memorandum by Mr J.M. Keynes to the commitee

of economists of the Economic Advisory Council, p.180, as reprinted in Keynes (1973,

pp.178-200)].

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which could be compatible with Keyness involuntary unemployment defi-

nition14, this outcome is much less in harmony with Keyness involuntary

unemployment theory since unemployment due to a real wage rate which is

too high as compared to the market-clearing value (without any clear rea-

son for this, which can be connected to effective demand deficiency) is more

similar to the classical than Keynesian concept of unemployment.15

While New Keynesian models of real wage rigidity deal with the persis-

tence of involuntary unemployment over time, the earliest NKE attempts to

provide rational microeconomic foundations to nominal wage rigidity relateto the issue of why (output and) unemployment fluctuates (e.g. Mankiw

1990). I refer to the long-term and staggered wage contract models initially

proposed by Fischer (1977), Phelps and Taylor (1977) and Taylor (1980).

In these models, the presence of explicit (or implicit) labour contracts pre-

determining the nominal wage for an agreed period can generate sufficient

nominal wage inertia. However, a criticism levelled at this literature is that

the time between renegotiations is exogenously determined. Thus critics have

pointed out that the existence of such contracts and their expiry dates are

not explained by solid microeconomic principles. Ironically, these models

which aimed at providing microeconomic foundations to Keyness argument

14Keyness famous (but also extraordinarily convoluted (Trevithick 1992, p.108)) def-

inition of involuntary unemployment is given on page 15 ofThe General Theory (all italics

in original):

Men 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.

It is clear that in the New Keynesian models discussed above a real wage decrease leads

to a reduction of involuntary unemployed workers according to Keyness definition.15Indeed some authors (e.g. McCallum 1989; Zenezini 1997) have pointed out that,

although these models are labelled as New Keynesian, they are very close to classical

and new classical theories of unemployment.

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of nominal wage stickiness have de facto proved less micro-founded than

Keyness original explanation. Moreover, from the perspective of real wage

dynamics, these models have the same problem as Keyness original theory.

In particular, with sticky nominal wages and movements along a standard,

downward-sloping, labour demand schedule, a negative shock to aggregate

demand is characterised by a decrease in output, employment and prices,

and by an increase in real wages (since nominal wages are sticky). Thus the

contribution of these models in explaining the observed real wage behaviour

during the business cycles is negligible.In this direction, instead, a real contribution has been provided by an-

other strand of NKE that turned the attention away from imperfections in

the labour market and toward those in the goods markets. In particular,

since evidence (e.g. Rotemberg and Woodford 1991) suggests that the ex-

pansion (recession) phase is associated with a decline (increase) in the degree

of monopoly (defined as the gap between price and marginal cost as a frac-

tion of price i.e. mark-up) in the goods markets, the assumption of free

competition in these markets needs to be relaxed for a more complete un-

derstanding of wages dynamics over business cycles.16 Thus, much effort of

NKE has been devoted to examining the behaviour of monopolistically com-

petitive firms in product markets which face small frictions such as menu

costs or near-rationality when they change prices (e.g. Mankiw 1985; Ak-

erlof and Yellen 1985; Blanchard and Kiyotaki 1987). These models seek to

explain, in rigorous microeconomic terms, the failure of price-maker firms

to restore equilibrium. In particular, when the shock is small, monopolisti-

cally competitive firms might not have the incentive to cut their prices when

demand for their goods declines because the benefit is small (second-order).

Yet, because of the preexisting distortion of monopoly pricing, the benefit for

society of a price cut may be large (first-order). In other words, with nom-

inal price rigidity, due to menu costs and/or near rationality, small shocks

16Kalecki (1939) was the first to advocate the importance of this factor.

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to nominal aggregate demand might cause large fluctuations in output and

employment.17 Moreover, these models do not imply a countercyclical real

wage. As firms have sticky prices, it is possible that they cannot sell all they

want at such prices if aggregate demand is reduced. This may move firms

off their (downward-sloping) labour demand schedule, leaving the path of

real wages indeterminate. Thus, once nominal price rigidity is considered,

real wages can also become a-cyclical (or slightly pro-cyclical) as evidence

suggests.

As with the New Keynesian models of real wage rigidity discussed above,there are also some important differences characterising NKE models which

explain nominal rigidities, both in wages and prices, with respect to Keyness

theory. First, in models of monopolistic competition and nominal price rigid-

ity, fluctuations in real output and employment are essentially due (for any

given path of nominal aggregate demand) to price stickiness while in such

models nominal wage behaviour is not so relevant in explaining those fluctu-

ations (Gordon 1990). Putting it another way, such New Keynesian models,

conversely from Keyness analysis, concentrate on nominal prices rather than

on nominal wages and say little about how wages are the dominant influence

on prices. Second, in New Keynesian models of nominal rigidities, without

such rigidities, flexible prices would be able to maintain full employment in

the economy. Although they do not analyse in detail specific mechanisms

by which falling wages and prices would ensure full employment, a sort of

hidden real balance effect implicitly seems to appear in most of such mod-

els: if wages and prices fell, the real value of individuals holdings of money

17In this direction, one important criticism of such an approach is that models with

nominal frictions can theoretically produce large nominal rigidities but do so for implausi-

ble parameter values, that is shocks must be too small and adjustments costs must be too

high to produce empirically observed behaviours and results. In response to this attack,

Ball and Romer (1990) have shown that substantial nominal rigidities can result from

a combination of real rigidities and small frictions to nominal adjustment, i.e. nominal

rigidities matter only if real rigidities matter.

17


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would increase and this would induce them to consume more. No attention,

instead, seems to be ascribed to the impact of nominal price changes on ef-

fective demand via expectations behind the investment demand function and

the liquidity preference schedule. By contrast, such aspects play a central

role in Keyness opinion concerning the ability of flexible wages (and prices)

to restore equilibrium and maintain full employment in economic systems

facing shocks. Given the importance of this issue, the next section covers it

in greater detail.

3 Nominal Wage Flexibility and Full Employ-

ment

Keyness explanation of wage behaviour has been the usual focus of discus-

sion and criticism. However, Keynes followed this with another important

argument sometimes ignored by New Keynesians. In Chapter 19 ofThe Gen-

eral Theory (Changes in Money-Wages) he came to the dynamic effects ofdownward nominal wage flexibility.

While neoclassical economists asserted that a reduction in nominal wages

is associated with an increase in employment, Keynes pointed out that 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 (GT,

p.259). In particular, he argued that, starting from an insufficient aggregate

demand and underemployment equilibrium, a policy of greater nominal wage

flexibility would be unlikely to generate forces powerful enough to lead the

economy back to full employment. On the contrary, the main result of this

policy would be to cause a great instability of prices so violent perhaps as

to make business calculations futile in an economic society functioning after

the manner of that in which we live (GT, p.269). In other words, wage

cuts were not the proper cure for unemployment and might not be a cure at

18


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all.18 This led Keynes to conclude that a policy of stable rather than flexible

nominal wages is probably the best macroeconomic environment:

When we enter on a period of weakening effective demand, a sud-

den large reduction of money-wages to a level that no one believes

in its indefinite continuance would be the event most favourable to

a strengthening of effective demand. But this [...] is scarcely prac-

tical politics under a system of free wage-bargaining. On the other

hand, it would be much better that wages should be rigidly fixed and

deemed incapable of material changes, than that depressions should

be accompanied by a gradual downward tendency of money-wages ...

(GT, p.265)

and

In the light of these consideration, I am now of the opinion that

the maintenance of a stable general level of money wages is, on balance

of considerations, the most advisable policy for a closed system. (GT,

p.270)

Before moving on to analyse in detail Keyness reasons for the statements

quoted above, it is important to keep in mind that such a point, as made by

Keynes, is quite different from that of why labour markets do not clear at

the microeconomic level, which was discussed in the previous section referring

to New Keynesian theories of real rigidities in the labour markets. In The

18In a conference meeting held in Chicago in 1931 Keynes explicitly asserted that There

is scarcely one responsible person in Great Britain prepared to recommend [wage cuts]

openly. [An economic analysis of unemployment, p.360, as reprinted in Keynes (1973,

pp.343-67)]. In another influential article, in order to regain international price competi-

tiveness, reduce unemployment and improve the living standards of the working class, he

advocated relative (compared to labour productivity) instead of absolute wage reductions,

that is squeezing the higher wages out of increased efficiency [The question of high

wages, p.11, as reprinted in Keynes (1981, pp.3-16)].

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General Theory Keynes considered the effects of a nominal wage reduction

(or flexibility) for economy-wide markets. He argued that, while in an open

economy a reduction of nominal wages relative to nominal wages abroad

would be favourable to investment since it will tend to increase the balance

of trade (GT, p.262)19, in a closed economy the way in which nominal wage

cuts would cure unemployment and return the economy to full employment

equilibrium could operate primarily through their impact on the interest

rate. Holding a nominal quantity of money constant, a decline in prices

which follows that of nominal wages will produce an increase in the realquantity of money and then a decrease in interest rate. This will generally20

lead to an increase in aggregate demand via investment expenditure which

could contribute to restore full employment. As Keynes gave such theoretical

importance to this effect, it is often referred to as the Keynes effect. In

sum, for Keynes the policy of allowing nominal wages to fall for a given

(nominal) money supply could, in theory, produce the same effects as a policy

of expanding the money supply with a given nominal wage. Since this was

the case, wage cutting was nevertheless subject to the same obstacles of

monetary policy as a method of securing full employment:

We can, therefore, theoretically, at least, produce precisely the

same effects on the rate of interest by reducing wages, whilst leaving

the quantity of money unchanged, that we can produce by increasing

the quantity of money whilst leaving the level of wages unchanged. It

follows that wage reductions, as a method of securing full employment,

are also subject to the same limitations as the method of increasing

19At the same time, however, Keynes maintained that unemployment would be reduced

only in local industries competing with foreign suppliers while the overall effect on unem-

ployment would be more complex to predict. For reasons explained in the Introduction, the

analysis in this paper concentrates on a closed economy. Rohwedder and Herberg (1984)

provide a systematic treatment of the production cost effect relative to the purchasing

power effect in relation to a variation of nominal wages in an open economy.20This does not hold true if under-utilization of capacity exists.

20


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the quantity of money. (GT, p.266)

Keynes introduced two main theoretical reasons why the Keynes effect

might fail. First, if interest rates are very low the demand for money becomes

perfectly elastic with respect to interest rates. In this liquidity trap case,

about which Keynes said that whilst this limiting case might become prac-

tically important in future, I know of no example of it hitherto (GT, p.207),

each real money supply increase is followed by a money demand increase of

the same amount. Thus, interest rate and investment expenditure do not

change. Second, the role of the business expectations (animal spirits) and

the marginal efficiency of capital might render the investment expenditure

less sensitive, and perfectly inelastic at the extreme, to interest rates. In these

two cases, falling nominal wages and prices would be unlikely to stimulate

aggregate demand and increase output and employment.21 Keynes, however,

did not consider adequately another more direct effect that falling wages and

prices can produce, namely increasing real wealth in the form of increased

real value of base money, which in turn increases aggregate demand via arise in consumption expenditure and, possibly, also in investment expendi-

ture as wealth-owners seek to maintain portfolio balance between real and

nominal assets (Tobin 1993). This effect, commonly labelled as the Pigou ef-

fect or real balance effect (Pigou 1943, 1947; Patinkin 1948)22, clearly does

not depend on reduction of interest rates. Thus, after the Second World

War, Neoclassical Synthesis economists have interpreted and presented The

21As is well known, during the 1960s the neoclassical synthesis incorporated these two

cases in the IS-LM model as special or limiting cases: a perfectly horizontal LM for the

liquidity trap case and a perfectly vertical IS for the interest-inelastic investment case.22Some authors (e.g. Presley 1986) have suggested that Keynes anticipated the real

balance effect but rejected it on both theoretical and practical grounds (see also Kalecki

(1944) for a theoretical attack on the real balance effect). Also Patinkin (1948), who

conversely stressed its theoretical importance, disclaimed belief in its practical significance

pointing out that in the Great Depression the real value of net private balances rose by

46 percent from 1929 to 1932 but real national income fell by 40 percent.

21


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General Theory as a special case in which downward nominal wage rigid-

ity is necessarily required to prevent the neoclassical automatic adjustment

to full employment (see, in particular, Modiglianis ground-breaking article

(Modigliani 1944)).

Indeed, the most important point, which has been too often forgotten over

time by a number of (old and new) Keynesian economists, is that Keynes did

not himself stop to consider the two special cases in which the standard wage

reduction remedy does not work. He also proposed the stronger argument

that greater wage flexibility might be even a self-defeating way to achieveequilibrium at full employment. In particular, Keynes focused on the role of

economic agents expectations:

If the reduction of money-wages is expected to be a reduction rel-

ative to money wages in the future, the change will be favourable to

investments because [...] it will increase the marginal efficiency of cap-

ital; whilst for the same reason it may be favourable to consumption.

If, on the other hand, the reduction leads to the expectation, or even tothe serious possibility, of a further wage reduction in prospect, it will

have precisely the opposite effect. For it will diminish the marginal

efficiency of capital and will lead to postponement of both investment

and consumption. (GT, p.263, italics in original)

The adverse effect on the investment expenditure of a reduction in nom-

inal wages which leads to the expectation of a severe deflation of prices in

the future may be better understood if we consider the well-known Fisherequation which states that the (expected) real interest rate is (approxi-

mately) equal to the nominal interest rate minus the expected rate of in-

flation (re i e). Greater expected deflation (e < 0) can produce an

increase in the real rate of interest, which is businesss real cost of borrow-

ing, and it is necessarily so when nominal interest rates are constrained by

the zero floor of the interest on money. Of course, Keynes stressed that such

22


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a problem does not emerge if a nominal wage reduction is believed to be one

in which nominal wages have touched the bottom, so that further changes

are expected to be in the upward direction (GT, p.265). At the same time,

he also suggested that a large reduction in nominal wages to such a low level

would be difficult to achieve in a system of free and desynchronised wage

bargaining.

The impact of severe deflation on the propensity to consume and invest

was also likely to be adverse due to the distributional effect that such deflation

produces (GT, pp.262-4). In particular, the net effect of transfers from wage-earners to other factors and from entrepreneurs to rentiers is more likely to

be negative on the propensity to consume. Generally, as long as debtors

are able to repay their obligations,23 price declines make creditors better off

and debtors poorer, but their respective marginal propensities to spend need

not be the same and common sense suggests that debtors have the higher

spending propensities (that is why they are in debt!).24 Distributional effects

are likely to be adverse also for investment expenditure since deflation mainly

penalises highly leveraged firms and this could produce negative effects for

the financial system, reducing banks propensity to finance new investments

(GT, p.264-7).25

23If this is not the case (i.e. danger of bankruptcies), declining prices may produce even

more disastrous effects, as we shall see below.24This point was emphasised before Keynes by Fisher (1933), who indicated the in-

creased burden of debt resulting from unanticipated deflation as a major factor in de-

pressions in general and in the Great Depression in particular. For such a reason, Tobin,

who more recently analysed this issue formally (Tobin 1975; 1980, Ch.1), defined it as theFisher, or reverse Pigou-Patinkin, effect (not to be confused with the other Fisher effect

discussed above). In particular, Tobin pointed out that if inside assets and debts wash

out in accounting aggregation does not mean that the consequences of price changes on

their real values wash out. This is because marginal propensities to spend from wealth

need not be the same for creditors and debtors. Moreover, [many debtors] are liquidity-

constrained, and as their debt/equity ratios increase their credit lines dwindle or, in case

of bankruptcies, disappear (Tobin 1975, p.197).25Keynes advanced this point in more detail also in The economic consequences to the

23


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In conclusion, in Keyness own view, a reduction in nominal wages can

help to bring about recoveries if it is believed to be temporary and that it will

be quickly reversed. On the contrary, if it leads to the expectation of future

severe deflation, and the negative effects explored above outweigh the real

balance and Keynes effects combined (this is quite possible particularly when

output and employment are low relative to capacity (e.g. Tobin 1980, Ch.1)),

aggregate demand will decrease rather than increase since both consumption

and investment expenditures are discouraged or postponed. In other words,

economic agents pessimism will turn recession into depression. Moreover,fluctuations of prices and instability of short-run employment equilibrium

would be reduced with a rigid (nominal) wage policy (GT, p.271).

Although during the late 1970s and early 1980s some economists re-

explored the notion that wage and price rigidity is not the only problem

and perhaps not even the main problem,26 most New Keynesians seemed

not to take into account such prominent messages. Indeed, the enormous

importance ascribed by some New Keynesians to nominal wage and price

rigidities would not find valid justification if such rigidities were not believed

to be the main causes of the persistence and fluctuations of unemployment

over time (i.e. increasing wage and price flexibility would produce positive

effects). Hence, this strand of NKE completely ignores Keyness concerns

about the possibility that nominal wage reductions were not the proper cure

for unemployment.

There are, however, some other New Keynesian theories which, albeit

with substantially different features, seem to reinforce Keyness opinion on

banks of the collapse of money values [as reprinted in Keynes (1972, pp.150-8)].26Tobins works have been already cited and discussed (see footnote 24). He also re-

marked that Keynes was well aware of the dynamic argument that declining money wage

rates are unfavourable to aggregate demand. But perhaps he did not insist upon it strongly

enough, for the subsequent theoretical argument focused on the statics of alternative stable

wage levels (Tobin 1975, p.195). Other notable works in the same vein are Hahn (1984),

Schultze (1985), Hahn and Solow (1986) and De Long and Summers (1986).

24


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this issue. In particular, Greenwald and Stiglitz (1993a,b) have been influen-

tial in developing New Keynesian models which do not rely on nominal price

and wage inertia (although real rigidities play an important role):

A number of facts imply that price rigidities are, at a minimum,

not the only source of economic problems [...] For example, Keynesian-

like unemployment problems seem to arise even in economies which

are experiencing inflationary pressures, and thus where the nominal

wages do not need to fall, but only to rise more slowly. Moreover,

nominal wages and prices did fall in the Great Depression [...] We

agree with Keynes that had prices fallen even faster, the economy

would have degenerated farther, rather than improving more quickly.

(Greenwald and Stiglitz 1993b, p.36, italics in original)

The authors consider risk-averse firms which, due to the presence of finan-

cial market imperfections generated by asymmetric information and incom-

plete contracts, are constrained in accessing equity finance. Their resultant

dependence on debt rather than new equity issues makes firms more vul-nerable to bankruptcy, especially during a recession. In such a situation a

risk-averse equity-constrained firm prefers to reduce its output because the

uncertainties associated with price flexibility are much greater than those

from quantity adjustment. Greenwald and Stiglitz argue that, as a firm pro-

duces more, the probability of bankruptcy increases and since bankruptcy

imposes costs, these will be taken into account in firms production deci-

sions. Indeed, in such a framework, nominal price and wage flexibility, by

creating more uncertainty, would in all likelihood make the situation worse,

inducing firms to further reduce output and employment. For instance, an

unanticipated wage-price reduction might actually serve to exacerbate a re-

cession, rather than recover economic performance, by worsening the working

capital base of firms and making them more reluctant to produce, if they be-

lieve current declines in prices will continue in the future (Greenwald and

Stiglitz 1987, pp.127-32).

25


26/33

Some ingredients of this theory of the risk-averse firm seem to be consis-

tent with an important feature of Keyness original thought. In particular, as

already discussed, Keynes pointed out that an incisive nominal wages decline,

by determining a decline in product prices, may have large adverse effects on

profits and financial position (or liquidity) particularly for highly leveraged

firms. As a consequence, lenders, particularly banks, face the risk that loans

will not be repaid. Moreover, if also banks are highly leveraged, the risk of

bankruptcy increases also for them and the overall financial system would

suffer, with consequent disastrous effects on output and employment. Thisstory plays a central role in the Greenwald-Stiglitz framework:

[The theory of the risk averse firm] contains three basic ingredients

[...]: risk averse firms; a credit allocation mechanism in which credit-

rationing, risk-averse banks play a central role; and new labor market

theories, including efficiency wages and insider-outsider models. These

building blocks should help to explain how [wage and] price flexibility

contributes to macroeconomic fluctuations and to unemployment. Inparticular, the first two blocks will explain why small shocks to the

economy can give rise to large changes in output, while the new labor

market theories will explain why those changes in output [...] result

in unemployment. (Greenwald and Stiglitz 1993b, p.26)

In particular, as emerges from the statement quoted above, the first two

blocks come close to Keyness original idea, enriching it with recent devel-

opments obtained by modern theories of credit markets with asymmetricinformation and credit-rationing (Greenwald and Stiglitz 1987). At the same

time, however, the framework outlined by Greenwald and Stiglitz presents

an important distinguishing feature. In particular, the third block explicitly

refers to the New Keynesian theories of the labour market, discussed in Sec-

tion 2.2, in which (involuntary) unemployment is strongly founded on real

wage rigidity. However, for reasons that have been outlined above, those

26


27/33

theories markedly differ from that of Keynes in some important aspects.

Most of all, Keynes assigned no central role to wage rigidity in theoretically

explaining the presence and persistence of involuntary unemployment.

4 Concluding Remarks

This paper has described and compared different contributions of NKE with

respect to Keyness original work on wages and unemployment, pointing out

the major differences and similarities.Like Keynes, New Keynesians also consider persistent involuntary un-

employment as being a central and continuing problem. At the same time,

referring to the role of nominal and/or real wages behaviour in explaining

unemployment, New Keynesian theories present important features which

differ, sometimes substantially, from the ideas and concepts developed by

Keynes in his General Theory.

In particular, in Keyness view real wages would be adjusted according

to the level of employment corresponding to the actual amount of effective

demand. Thus, according to Keynes, effective demand determines the real

wage rate as well as output and employment. At the same time, he denied

any direct influence of the real wage on (un)employment and he believed that

nominal wage cuts (or flexibility) was not the main cure for unemployment,

and might not be a cure at all.

By contrast, modern New Keynesian theories of the labour market (e.g.

efficiency wages and insider-outsider) emphasise the role of real wage rigidity

in explaining involuntary unemployment, while those which stress the role of

nominal rigidities, both in wages and prices, do not seem to take into account

Keyness concerns about the possibility that greater nominal flexibility could

exacerbate the economys downturn and increase unemployment. In this last

direction, however, there are some New Keynesian models which seem to

reinforce Keyness opinion, albeit with major distinguishing features.

27


28/33

In conclusion, NKE has restored to favour typical Keynesian arguments

that seemed to be forgotten during the 1970s, namely skepticism in the abil-

ity of the markets invisible hand to maintain full employment. It has also

provided new contributions on some issues that, with respect to Keyness

work, should be investigated in greater detail (e.g. the role of imperfect

competition in goods and labour markets). At the same time, NKE does

not fully incorporate some of Keyness greater insights. Too often the only

Keynesian characteristics of New Keynesian models are the final results (i.e.

persistent unemployment and economic fluctuations), while everything elseremains largely neoclassical. In particular, Keynesian results are obtained

by introducing (with robust and well-defined micro-foundations) some im-

perfections, namely nominal and/or real rigidities in wages (and prices),

which hamper de facto classical adjustment processes to full employment.

By contrast, Keyness final results were obtained in a different theoretical

framework in which (nominal and real) rigidities did not play any central

role. Furthermore, in some cases New Keynesian theories seem also to join

traditional neoclassical economics in suffering from a fallacy of composition,

in the sense that their wholes are simply the sum of their parts and, as a con-

sequence, some major effects deriving from interaction among different parts

remain hidden from analysis, something Keynes would never have done!

28


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Keynes and NKE