Determination of Employment in Keynes’s General Theory
All present discussions of employment theory cannot but take Keynes’s General Theory as their starting point - and yet the interpretation of the latter remains highly controversial.
One point in particular calls for attention: textbook presentations of Keynes’s theory of employment claim (1) that it is a short-run theory of cyclical fluctuations and/or that (2) it rests on the assumption of money wage rigidity. And yet it is possible to find in the General Theory very explicit statements to the contrary. In chapter 1 Keynes writes:
I have called this book The General Theory of Employment, Interest and Money, placing the emphasis on the prefix general... I shall argue that the postulates of the classical theory are applicable to a special case only and are not the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium. (Keynes 1936 [1978]: 3)
In the following chapter he explicitly acknowledges the existence of many theories dealing with the fluctuations in employment, but maintains that the fundamental theory, which assumes an underlying tendency towards the full employment of resources, has never been questioned (Keynes 1936 [1978]: 4-5, n. 1). The whole of chapter 19 is devoted to showing that the assumption of given money wages made in previous chapters is not necessary to his conclusions and to analysing the effects of downward wage flexibility. Hence textbook interpretations are at variance with Keynes’s declared purposes and can be justified only by the claim that, whatever the intentions, Keynes’s conclusions on employment theory can be given sound foundations only under the above listed conditions. As we shall see below, this is precisely the result arrived at by the so-called neoclassical synthesis initially proposed by Hicks (1937) and Modigliani (1944), which became the basis of all subsequent macroeconomic debates and developments in mainstream economics.
This conclusion, though conflicting with Keynes’s intentions, may be justified by certain weaknesses in Keynes’s own analysis and assumptions.Let us very briefly go through Keynes’s theory of employment. As already mentioned, Keynes’s criticism of received theory took as its point of attack Say’s law, without however questioning the marginalist foundations of the theory, that is, the theoretical constructs of factor demand curves.
The positive kernel of his contribution is the principle of effective demand, showing that equilibrium between aggregate investments and savings can be reached through changes in output and employment levels, by which aggregate savings adjust to the level of aggregate investments, given the propensity to consume. The possibility of determining a definite equilibrium level of output and employment following a change in the components of aggregate demand by means of the multiplier represents an important progress with respect to earlier analyses recognizing a role of aggregate demand in the determination of employment, as in Marx and the Marxist tradition.
The principle of effective demand as formulated by Keynes, however, called for a determination of the interest rate that is alternative to the received one in terms of demand and supply functions of savings (as a flow) or demand and supply of capital (as a stock). This Keynes accomplished with his theory of a monetary determination of the interest rate. On the other hand, Keynes did not question the Marshallian foundation of economic theory, and retained both the notion of a decreasing curve of the marginal product of labour (yet hardly consistent with the existence of unused fixed capacity owing to a lack of effective demand) and of a decreasing function of aggregate investments with respect to the interest rate.
On these premises, Keynes’s theory may be represented as a sequence, going from the determination of the interest rate in the money and financial market, to the amount of aggregate investments which, given the propensity to consume, determines output and employment. The price level would reflect marginal labour productivity and hence marginal costs at the level of employment thus determined and hence, with a given money wage, the real wage would tend to equal the marginal labour productivity via changes in the price level.
This explains how in the General Theory the labour market only plays a passive role: both employment and real wage are in fact determined by effective demand.It may be noted here that Keynes’s analysis, precisely because it retains the notion of a decreasing marginal product of labour, entails the real wage being countercyclical: it falls when employment increases and vice versa. When confronted with the empirical results obtained by Dunlop (1938) and Tarshis (1938) which indicated pro-cyclical wage movements, Keynes (1939) wrote that those results, which appear to contradict the inverse relation between real wages and employment, would indeed provide further support for his analysis, though he was reluctant at the time to abandon the traditional Marshallian premises on the basis of that empirical evidence alone.
However, what if, when some involuntary unemployment exists, wages are flexible downward? First, Keynes observes that workers cannot bargain directly on real wages, but only on money wages. The natural question, within the framework outlined here, therefore is: can a fall in money wages lead to an increase in effective demand, that is, cause an increase in the propensity to consume and in the marginal efficiency of capital, or cause a fall in the interest rate? On these points chapter 19 of the General Theory offers very articulate arguments, leading to a negative answer concerning the possibility that unemployment can be overcome by means of wage flexibility. Of particular interest among these is the argument that a fall in wages, if it leads to real income redistribution away from labour incomes towards profits and other high incomes, will lead to a lower propensity to consume and hence have negative effects on aggregate demand and employment. On the other hand, if it is accompanied by price deflation and by expectation of a further fall in the price level (owing to the fall in monetary costs of production) it may cause a fall in aggregate demand owing to the decrease in expected returns from investment, the increase of debt burden, and the postponement of expenditure in durable consumption and investment goods.
Given such negative effects, an increase in real money balances, which might lead to a fall in interest rates and hence in an improvement of aggregate investments, ought not to be pursued by means of wage and price deflation: monetary policy would definitely be better suited. However, according to Keynes, even monetary policy would hardly be capable of maintaining investments at the level required to keep the economy at full employment, owing to the difficulties it would encounter in regulating interest rates and, via them, aggregate investments. Among these, liquidity trap phenomena could be set in motion by attempts to lower interest rates below the expected or conventional level, or by the pessimistic expectations typical of a depressed economy. From this it follows that public expenditure management is a necessary tool to maintain high levels of employment in a market economy. In addition, since downward wage flexibility is shown to be unable to stimulate higher employment, and since it is likely to have adverse consequences on economic stability, Keynes concluded that the existence of money wage rigidity is desirable as it provides an anchor to money prices and thus prevents deflation and economic instability (Keynes 1936 [1978]: 270-71).