New-Keynesian macroeconomics and involuntary unemployment

21 Mar, 2012 at 16:25 | Posted in Economics | 7 Comments

People calling themselves “new-Keynesians” – a gross misnomer – ought to be rather embarrassed by the fact that the kind of microfounded dynamic stochastic general equilibrium models they use, cannot incorporate such a basic fact of reality as involuntary unemployment!

Of course, working with representative agent models, this should come as no surprise. If one representative agent is employed, all representative agents are. The kind of unemployment that occurs is voluntary, since it is only adjustments of the hours of work that these optimizing agents make to maximize their utility.

Being a “new-Keynesian” it ought to be of interest to know what Keynes had to say on the issue. In General Theory (1937, chapter 2), he writes: 

The classical school [maintains that] while the demand for labour at the existing money-wage may be satisfied before everyone willing to work at this wage is employed, this situation is due to an open or tacit agreement amongst workers not to work for less, and that if labour as a whole would agree to a reduction of money-wages more employment would be forthcoming. If this is the case, such unemployment, though apparently involuntary, is not strictly so, and ought to be included under the above category of ‘voluntary’ unemployment due to the effects of collective bargaining, etc …

The classical theory … is best regarded as a theory of distribution in conditions of full employment. So long as the classical postulates hold good, unemployment, which is in the above sense involuntary, cannot occur. Apparent unemployment must, therefore, be the result either of temporary loss of work of the ‘between jobs’ type or of intermittent demand for highly specialised resources or of the effect of a trade union ‘closed shop’ on the employment of free labour. Thus writers in the classical tradition, overlooking the special assumption underlying their theory, have been driven inevitably to the conclusion, perfectly logical on their assumption, that apparent unemployment (apart from the admitted exceptions) must be due at bottom to a refusal by the unemployed factors to accept a reward which corresponds to their marginal productivity …

Obviously, however, if the classical theory is only applicable to the case of full employment, it is fallacious to apply it to the problems of involuntary unemployment – if there be such a thing (and who will deny it?). The classical theorists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight – as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is required to-day in economics. We need to throw over the second postulate of the classical doctrine and to work out the behaviour of a system in which involuntary unemployment in the strict sense is possible.

The final court of appeal for macroeconomic models is the real world, and as long as no convincing justification is put forward for how the inferential bridging de facto is made, macroeconomic modelbuilding is little more than “hand waving” that give us rather little warrant for making inductive inferences from models to real world target systems. If substantive questions about the real world are being posed, it is the formalistic-mathematical representations utilized to analyze them that have to match reality, not the other way around.



  1. But if it’s not because of rigid nominal wages [price restrictions] nor because “of temporary loss of work of the ‘between jobs’ type [frictional unemployment] or of intermittent demand for highly specialised resources [structural unemployment] or of the effect of a trade union ‘closed shop’ on the employment of free labour [quantity restructions]” What is it then??? Enlighten me!

  2. And this is a question to have from a lecturer in economics at Cambridge University! Keynes probably turns in his grave. Wouldn’t it be appropriate to at least have read General Theory once, when taking up a position at THAT university?
    For an answer – how about genuine uncertainty and effective demand?

  3. By the way, I can see how there can be a general glut (as the classics would call it) for money, and therefore a general decline in the nominal demand for goods. However, for this decline in nominal demand to bite we need some nominal rigidities. Otherwise there always exist a price and wage adjustment such that the nominal demand change is inconsequential for the real economy.

    • J M Keynes, General Theory (chapter 19):
      “It follows, therefore, that if labour were to respond to conditions of gradually diminishing employment by offering its services at a gradually diminishing money-wage, this would not, as a rule, have the effect of reducing real wages and might even have the effect of increasing them, through its adverse influence on the volume of output. The chief 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. To suppose that a flexible wage policy is a right and proper adjunct of a system which on the whole is one of laissez-faire, is the opposite of the truth.”

  4. “[a reduced] money-wage [would not have] the effect of reducing real wages and might even have the effect of increasing them, through its adverse influence on the volume of output.”

    That argument makes absolutely no sense at all. Either lower money wages for some reason leads to less output and prices would increase (the same amount of money chasing fewer goods), therefore crippling real wages, or lower wages would raise employment and hence output. Just saying “this will not lead to [x]” is not an argument you know. Rather, it’s religion.

    • Is it possible to be a physicist and not knowing Newton or Einstein? I don’t think so.
      But, today, obviously, it is possible – at least in Cambridge (of all places!) – to be a macroeconomist not knowing Keynes.
      It’s heart-sickening!

  5. Why don’t you answer my question instead: Do I understand you correctly that lower nominal wages may reduce output and therefore reduce prices? How could that even happen? The mere fact that nominal wages fall for yet to be filled positions can have two consequences: Either job is not filled, and output is not affected. Or the job is filled, and output increases (one addition worker contributing to GDP, you know). Please explain to me how lower nominal wages for yet to be filled positions can lower output.

    Then the argument follows that these rises in real wages (how the hell that happened!) will cause “a great instability of prices, so violent perhaps as to make business calculations futile”. I think this point needs to be elaborated upon. It’s a “little bit” of “handwaving”, don’t you agree.

    Tell me when you disagree with my logic, and maybe I can understand your argument.

    Second, I’m not even sure what it means to know Keynes. There are hundreds and yet hundreds of books trying to “make sense” of, and interpret, Keynes. And they are not even consistent with each other! Keynesian conferences are much like Islamic science, in which the whole game is to find a sentence in the General Theory (or the Qu’ran) which had already predicted the housing crisis (or the Higgs boson). It’s a little sad. But what is even worse is that when people like Krugman revert back to Keynesian ideas, he reverts back to the 30’s. He happily dismisses 70 years of post-keynesian research by not even discussing it.

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