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Keynesian and Classical Unemployment in Four Countries

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Keynesian and Classical Unemployment in Four Countries ROBERT M. COEN Northwestern University BERT G. HICKMAN Stanford University Keynesian and Classical Unemploymentin Four Countries THE WORLD ECONOMY entered a period of stagflationduring the 1970s. Markedly slower growth combined with rates of unemployment and inflationthat were unprecedentedlyhigh for the postwar era, and the slowdown persists to this day. In this paper we draw on a larger study of the deceleration of potential growth to emphasize the contributory role of demandshortfalls in prolongingand deepeningthe adjustmentto lower growth rates of productivityand real wages. A key issue is the relative importanceof high real wages and deficient aggregatedemand as proximatecauses of the rise of unemployment. We use the theoreticalapproach developed by Hickmanto estimate the classical and Keynesian componentsof excess unemploymentin the United States, Germany, Austria, and the United Kingdom.1The ap- proach is closely related to the "wage gap" analysis of Michael Bruno This paperis partof a researchproject on unemployment,real wages, and economic growthin selectedOECD countries. The supportof the AustrianNational Bank is gratefully acknowledged.We are indebtedto the BrookingsPanel and to Erich Streissler, Stefan Schleicher,Stephen King, GeorgeEvans, Jean Waelbroeck,and seminarparticipants at the Universityof Vienna,Project LINK, and StanfordUniversity for theircomments and suggestions.Thanks are also due to ChristianStadlinger for his valuableassistance. 1. BertG. Hickman,"Real Wages, Aggregate Demand, and Unemployment"(Center for EconomicPolicy Research, Stanford University, July 1986).Forthcoming in European Economic Review. 123 124 Brookings Papers on Economic Activity, 1:1987 andJeffrey Sachs, butit differsin buildingon the assumptionof imperfect competitionand cost minimizationrather than perfect competitionand profitmaximization as the basis for labor demand.2Similarly, it differs fromthe generaldisequilibrium or non-market-clearingmodels of Robert Barroand Herschel Grossmanand EdmondMalinvaud in that it allows for coexistence of classical and Keynesian unemploymentinstead of explainingthem as separateregimes in marketswith price-takingfirms and rationedbuyers and sellers.3 Our empirical measures of the wage and demand components of employment are computed from a conditional demand function for aggregateman-hours, with the real wage and outputtreated as predeter- mined to the employment decisions of firms. Since the real wage and aggregatedemand are in realityendogenous variables, the decomposition deals only with their relative importance as proximate sources of unemployment.A deeper approachwould employ a complete macro- economic model endogenizing aggregate output and real wages and capable of explainingthe evolution of both as a function of exogenous shocks to aggregate supply and demand, as recommendedby Robert Solow.4 That would be feasible in our U.S. model, which is just such a complete system, but not in the truncatedsupply-side models we have estimatedfor the Europeancountries in the study. Concepts of Keynesian and Classical Unemployment The standardfixed-price or non-market-clearingmodel distinguishes Keynesianand classical unemploymentstates as separateregimes under fixed wage and price levels by incorporatingquantity constraints into the optimizationproblems of firmsand households.5 2. Michael Bruno and Jeffrey D. Sachs, Economics of Worldwide Stagflation (Harvard UniversityPress, 1985). 3. RobertJ. Barroand Herschel I. Grossman,"A GeneralDisequilibrium Model of Incomeand Unemployment,"American Economic Review, vol. 61 (March1971), pp. 82- 93; Edmond Malinvaud, The Theory of Unemployment Reconsidered (Oxford: Basil Blackwood, 1977). 4. Robert M. Solow, "Unemployment:Getting the Questions Right," Economica, vol. 53 (Supplement,1986), pp. S23-S34. 5. Basic references include Don Patinkin, Money, Interest and Prices: An Integration of Monetaryand Value Theory,2d ed. (Harperand Row, 1965);Robert Clower, "The Robert M. Coen and Bert G. Hickman 125 The representativefirm is a price taker in its marketsfor inputs and output. It maximizes profits subject to a well-behaved production function, Y = F(K,L), and a product demand constraint, Y c Y. For fixed K in the short run, the optimalsolution for L is the min-equation (1) Ld = min[F- 1 (Y,K), FL 1 (WIP,K)], where WIPis the real productwage. The unconstrainedor notional short-runfunctions for labor demand and productsupply are (2) Ld = FL1 (WIP,K), given by the first-ordermarginal productivity condition, and (3) ys = F(Ld,K). The classical labor supplyfunction is (4) Ls = Ls(W/P), where the real wage equates the marginaldisutility of effort and the marginalutility of consumption. With flexible wages and prices, a Walrasiansolution of equations 2 and 4 would yield full employment at the equilibriumreal wage. With fixed wages and prices, however, if notional supply exceeds effective demandat the given price, the sales of firmsare rationedin the product market. Labor demand is then output-constrainedand is smaller than laborsupply at the existing real wage, resultingin Keynesianunemploy- ment: (5) Ld = F-1 (Y,K) < Ls (WIP). Thus Keynesian unemploymentis the spillover effect of disequilibrium in the productmarket. Classical unemploymentmay occur if the fixed price is below the Walrasianequilibrium level. Effective demand then exceeds notional KeynesianCounterrevolution: A TheoreticalAppraisal," in F. H. Hahn and F. P. R. Brechling, eds., The Theory of Interest Rates (London: Macmillan, 1965), pp. 103-25; Barroand Grossman, "A General DisequilibriumModel"; Malinvaud,The Theoryof UnemploymentReconsidered; Jean-PascalBenassy, "Neo-Keynesian Disequilibrium Theory in a Monetary Economy," Review of Economic Studies, vol. 42 (October 1975), pp. 503-23; Jean-Pascal Benassy, The Economics of Market Disequilibrium (Academic Press, 1982). 126 Brookings Papers on Economic Activity, 1:1987 supply. Firms have no incentive to increase supply at the existing real wage, so the short side of the market prevails and households are rationed.Firms are unconstrainedand operatingon their notionallabor demandand output supply schedules, but since the real wage exceeds the Walrasianlevel, labor demandfalls short of full-employmentlabor supply. In both unemploymentstates householdsare constrainedin the labor market, and hence effective demandfalls short of the notional demand that would result from unconstrainedutility maximization.Indeed, as Robert Clower showed, it is because of the spillover from the labor market constraint that income is an argument in the consumption function.6 However, the approach of this paper modifies the standardfixed- price model, in which prices are fixed over the periodbeing analyzed, in two principal respects. First, we assume imperfect competition with firms setting prices in the face of uncertain demand. We assume that prices are not continually adjusted. Second, firms choose capital and labor inputs so as to minimize the cost of producingthe quantitythey expect to sell at the price they have set. The assumptionof imperfectcompetition is adoptedfor both theoret- ical and empiricalreasons. Perfect competitionamong atomistic price- takingfirms is incompatiblewith the fixed-priceassumption except for very shortadjustment periods afterunexpected shocks. As an empirical matter, moreover, auction markets are largely limited to agricultural productsand primarymetals. There is also solid econometricevidence of the ubiquitousexistence of cost-basedprice setting,with only a limited scope for markupvariations in response to shifts in productdemand.7 One important consequence of cost-based price setting is that it reduces the sensitivity of real wages to changes in effective demand. Increases or decreases in nominalwages induced by shifts in aggregate demandinduce price movements in the samedirection, greatly mitigating the response of real wages to demand pressures in labor markets. In contrast, supply shocks that directlyraise productioncosts, such as the 6. Clower, "The KeynesianCounterrevolution." 7. Otto Eckstein, ed., TheEconometricsofPriceDetermination, conference sponsored by Board of Governors of the Federal Reserve System and Social Science Research Council(Board of Governors, 1972);Phillip Cagan, "The Hydra-HeadedMonster: The Problemof Inflationin the UnitedStates," DomesticAffairs Study 26 (Washington,D.C.: AmericanEnterprise Institute, 1974); William D. Nordhaus,"The Falling Share of Profits," BPEA, 1:1974, pp. 169-208. Robert M. Coen and Bert G. Hickman 127 energy shocks of the 1970s, have greater potential to alter real wage rates unless they are offset by promptand substantialwage indexation. As a corollaryto real wage inflexibilityunder markup pricing, macro- economic models, includingour own, that incorporatethe hypothesis generallydepend for theirequilibrating properties on absolutevariations in the wage-pricelevel, operatingthrough the Phillipscurve and markup mechanisms. In the standard textbook IS-LM model, for example, restoration of long-term equilibriumafter a shock depends on price- inducedchanges in the real money supplyand interestrates.8 In some of the largereconometric models, real wealth argumentsin the aggregate demandfunctions are also involved.9 Market imperfectionsprovide a theoretical rationale for the fixed- price assumption.One theoreticalrationale is the perceived asymmetry of competitors'responses to a firm'spotential price increaseor decrease in oligopolistic industries as the source of price rigidity, as in Paul Sweezy's theory
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