KEYNESIAN AND NEW-KEYNESIAN THEORIES OF UNEMPLOYMENT AND THE BEHAVIOUR OF REAL WAGES
As mentioned above, two phenomena about the labour market need to be explained: the persistence if unemployment and the moderately pro-cyclical behaviour of real wages. When aggregate demand increases, labour markets respond typically by a larger increase in employment and a relatively smaller increase in real wages, i.e., quantities respond more than prices. But real wages do respond cyclically, however moderately.
This point helps us to understand the difference between Keynesian and New- Keynesian theories of unemployment. Though both kinds of theories help explain persistent unemployment, it is only some of the new-Keynesian theories that explain why wages behave pro-cyclically, though only moderately so. The Keynesian theory clearly implies that wages behave counter-cyclically. This follows from the assumption of a constant nominal wage. Given the nominal wage rate W, the real wage W/P falls during an expansion as the price level P gradually increases. It is this fall in the real wage that induces firms to employ more labour and produce higher output as aggregate demand increases. During contraction, on the other hand, real wages rise as prices fall, nominal wages remaining unchanged. The Keynesian model thus implies a counter-cyclical behaviour of real wages. This is not in accordance with the empirically observed behaviour of real wages. In real world we see that real wage increases during periods of boom and decreases during recession. The new-Keynesian models imply an advance over the Keynesian model to the extent that they imply a pro-cyclical behaviour for real wages, in accordance with empirical observations.