Keynesian view on unemployment, Managerial Economics


Keynes  in his General Theory presented  a view  that  fluctuations in  aggregate demand (AD) influences the equilibrium level of output. Thus the economy  is not necessarily at the full employment output level all the time and equilibrium can be realized at a level of output below full employment and corresponding to that level, part of  the  labour  force  remains  unemployed. Recall that  the Keynesian view emerged on the aftermath of the Great Depression when  there was widespread unemployment in the economy accompanied  by  declining prices and output. At  this point Keynes analysed  the problem  in the short run context and assumed  that  the aggregate supply (AS) curve  is  horizontal.  It implies that  AS  is  infinitely elastic and  any level  of  output can  be  supplied without increase in prices  so  long  as  unemployment  persisted. Keynes diagnosed the problem during the Great Depression to  be  a result of  demand deficiency and suggested that  AD  should  be  increased,  may  be  through increases  in government expenditure. In  fact,  fiscal policy  through appropriate designing of tax rates and government expenditure emerged as a major policy instrument largely due to the pioneering work of Keynes. 

In Fig.  we present an infinitely elastic AS curve and a downward sloping AD curve, the intersection of which provides us with equilibrium output (f) and  prices  (P*).  In  response to a  decline  in aggregate  demand  there is a downward  shift in AD to ADI. Corresponding to this shift there is a decline in  equilibrium output  from (Y*)  to (Y,'). Note  that price  level remains unchanged in the above model. In synchronization with the  level of output, the quantity of labour used in  production varies.  For  example, corresponding to a decline  in equilibrium output the quantity of  labour decreases. Simultaneously there is an increase in unemployment. 


Fig. : Equilibrium Output in Keynesian Model 

On the behaviour of wage rate, Keynes assumed that there is downward rigidity in nominal wage in the sense  that workers oppose decline in the money wage, as they  perceive  it  to  be  a decline  in  their income. During periods of  recession when there is a decline in price level, real wage increases in spite of the fact that W nominal wage remains fixed. Recall that we defined real wage as w  =  -  ;  hence P decline in P would  increase w when W is constant. The basic idea behind the simplest Keynesian model is that w  varies inversely with P  as W remains fixed. Thus in periods of boom, when  there is an increase in prices, real wage tend to decline. Consequently,  firms  hire  more  labour  and  unemployment  in  the economy is lower.

In  Fig.  we  discussed the  extreme Keynesian  case where  AS  curve  is horizontal.  On the basis of  Keynesian ideas,  economists  analyse  the unemployment issue by  resorting to an upward  sloping AS curve. As mentioned above, real wage falls when prices increase, as a result of which more labour is demanded. The outcome of such an increase is production of more output. Thus as price level increases we have increasing level of output, implying an upward sloping AS curve. The change  in  level of employment due to  change  in price level can be explained through the following diagram.

Fig.  comprises three segments. In panel-a we have described a production hction such  that corresponding  to  each level of output we  can  find out  the level of employment. Thus when output produced  is at full employment level (QJ  we have corresponding level of employment at Lj In  panel-b we plot the AS  curve which depicts the output supplied (Q)  at each price level  (P). Thus when Qf  is the output produced prevailing prices is Pj.  In panel-c we depict real wage (W/P)  on y-axis and employment level on x-axis. Note that we assume nominal rigidity in prices so that  W  is fixed. Thus real wage (w)  increases as P decreases. Through the interaction of L,  and Ld  we have full employment (Lj)  in the economy corresponding to real wage  Wf W/Pj  Thus we assume the initial position of the economy to be  full employment corresponding to Qj;  Lj,  Pf  and W/Pj  


Suppose there  is a decline in AD  (not given  in the figure). Consequen;ly,  there is a decline in equilibrium output fiom QI  to Ql and decline in prices fiom Pj  to PI  (see Fig. ). Corresponding to the new output  level Ql,  the  level of employment is Ll, which is less then Lf. In fig.  we see that a decrease in prices from P,  to PI  leads to an increase in real wage from W/P,  to W/P1.  At this level of real wage there  is  excess supply of  labour compared to  its demand. Thus unemployment to the extent 'U'  (as shown in Fig. takes place.

In Fig.  where we assumed the short run  AS curve to be horizontal, upward shift in AD  resulted in increase in output, keeping prices  unchanged. In  Fig.  on  the other hand, AS  is assumed to be upward-sloping and  shift in AD influenced both output and prices. 

We observe that nominal wage is not completely sticky in an economy. Keynes in fact recognized that nominal wage would adjust to the requirement of labour market equilibrium. However, such adjustments would be  too slow so that full employment may not prevail always. Adjustments in nominal wage in response to price changes is always with a  lag. For example, if nominal wage adjusts in period 2 but prices increase in period  1, there is a decline in real wage in period 1.  In period 2, however, nominal wage can be increased proportionately and real wage at  the previous  level be maintained. Salary  indexation followed in  India on a six-monthly basis is an example of such a lag in wage adjustments.  

Posted Date: 10/26/2012 6:11:50 AM | Location : United States

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