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Rejecting the Wage Flexibility Argument

By itself, Keynes's discrediting of the link between saving and investment was not sufficient to refute the classical claim of a full-employment equilibrium. Remember, the classical economists described two forces that ensure full employment in a market economy: interest rate adjustments and wage/price flexibility. If interest rate adjustments fail to synchronize the plans of savers and investors and if this results in too little spending, wage and price flexibility can still ensure full employment. In competitive labor and product markets, inadequate demand would lead to falling wages and prices, which, in turn, would guarantee that all output was sold and would thus prevent involuntary unemployment.

Again Keynes disagreed. He argued that the classical assumption of highly flexible wages and prices was not consistent with the real world. According to Keynes, a variety of forces prevent prices and wages from adjusting quickly, particularly in a downward direction. First, markets are less competitive than the classical theory assumed. Keynes saw that many product markets were monopolistic or oligopolistic. When sellers in these markets noted that demand was declining, they often chose to reduce output rather than lower prices. And in labor markets, particularly those dominated by strong labor unions, workers tended to resist wage cuts. As a consequence, wages and prices did not adjust quickly; they tended to be rigid or "sticky."

The consequences of rigid prices can be seen in Exh. 4, which uses the aggregate demand-aggregate supply framework. Let's consider the same scenario outlined in our discussion of the classical model. Assume that consumers become pessimistic about the future and decide to hoard some of their income. Aggregate demand will fall—the AD curve will shift from AD1 to AD2—be-cause households demand fewer goods and services at any given price level. This time we will make the assumption that the price level remains stuck at 100 because labor and other contracts prohibit reductions in input costs, which means that firms cannot afford to reduce prices. The assumption of rigid prices and wages implies a flat, or horizontal, AS curve since any reduction in aggregate demand leads to a reduced level of real GDP but no change in the price level. In this example the level of equilibrium GDP would decline from $1,000 billion to $800 billion. Businesses still want to produce $1,000 billion of output, but since they can sell only $800 billion, they must cut production back to that level. Of course, employment would also decline; if employers produce less real output, they require fewer workers. This is essentially the manner in which Keynes explained the Great Depression—as a problem caused by too little aggregate demand, combined with wage and price rigidity.

Although Keynes was concerned primarily with the problem of unemployment, he agreed with the classical economists that inflation would result

EXHIBIT 4. The Keynesian Aggregate Supply Curve

Keynesian Aggregate Supply Curve

if consumers, investors, and others attempted to purchase more than the economy was capable of producing. As you can see, the Keynesian AS curve becomes vertical at full employment. If aggregate demand was increased from ADj to AD3, the price level would be pushed up, without any increase in real output or employment.

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