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Is Unemployment due to Labour Market Institution or to Lack Of Effective Demand?

Is Unemployment due to Labour Market Institution or to Lack Of Effective Demand?

By the early 1950s, Keynes's theory was widely seen as valid by most professional economists. Keynesian theory is characterized by its importance to the explanation of involuntary unemployment, the real unemployment. Contrary to the classical theory, Keynes does not believe that our economic system can automatically ensure full employment. This is why Keynes prophesied development of the economic role of the state. According to KEYNES, unemployment is the result of low aggregate demand and is to be classed as an equilibrium phenomenon. Keynes explained it starting out from a confutation of Say's law, arguing that unemployment is impossible in a world where “every supply generates equivalent demand”.

In Keynes' view, unemployment is not caused by rigid money wages because a drop in money wages would not be enough to reduce unemployment, even in a situation with fully flexible wages. The decisive element is that prices are determined by production costs, so that a generalized fall in wages would result in a proportional decrease in prices and leave real wages unchanged. One further explanation is provided by the observation that a declining trend in money wages has an adverse effect on expectations (thus discouraging investment) because it is generally accompanied by the anticipation of further wage drops and, thus, a persistent downward movement in prices. The “liquidity trap” also acquires relevance in this connection.

Major criticisms of the Keynesian explanation of unemployment were voiced during the debate on the Phillips curve and by those who argued that this curve becomes vertical in the long run - a hypothesis that was set forth by monetarists and was later accepted by those Keynesians who theorize the existence of a NAIRU (non-accelerating inflation rate of employment). The monetarists' vertical Phillips curve places equilibrium at the full employment point; but even many Keynesians endorsing the idea of involuntary unemployment have ceased tracing back the long-run unemployment to low aggregate demand and now attribute it to the position of the NAIRU. Based on the argument that the comparatively weak real balance effect is counteracted by the much stronger “Fischer effect”, TOBIN has continued to endorse the validity of Keynes's views on the subject while calling into question the verticality of the long-run Phillips curve.

Along with Modigliani, many Keynesians are convinced that Keynesian unemployment must be traced back to a mismatch between money supply and money wages. For those who accept this idea, one explanation of Keynesian unemployment is FISCHER's and TAYLOR's (1979, 1980) theory of staggered contracts. Indeed, for those who assume unemployment to be caused by rigid money wages the first element to be explained is the rigidity of money wages, and this is what some periodic contract theorists are trying to do.

According to them, by keeping the wage structure stable over a given period and changing it at pre-fixed intervals of time, firms save money and time and, especially, ...
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