Cyclical Unemployment and Policy Prescription True to Keynes, We Tell Our Story Peak to Peak

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Cyclical Unemployment and Policy Prescription True to Keynes, We Tell Our Story Peak to Peak TIME AND MONEY fact that his discussion of cyclical variation is relegated to Book IV of the General Theory, titled “Short Notes Suggested by the General Theory,” and, more specifically, to a chapter entitled “Notes on the Trade Cycle.” Allowing cyclical unemployment to be the whole story as told with the aid of Figures 7.1 through 8.4 is strictly a matter of heuristics. After we have turned from the issues of cyclical unemployment and stabilization policy to the 8 issues of secular unemployment and social reform, we can easily transplant our entire discussion of business cycles into the context of an economy that is suffering from ongoing secular unemployment. Cyclical Unemployment and Policy Prescription True to Keynes, we tell our story peak to peak. Unlike the boom-begets- bust story that emerges from the capital-based macroeconomics of Chapter 4, the story told by Keynes opens with the bust. The onset of the crisis takes the FROM ACCIDENT TO DESIGN form of a “sudden collapse in the marginal efficiency of capital”–the Beginning with “Full Employment by Accident,” depicted in Figure 7.1, and suddenness being attributable to the nature of the uncertainties that attach to ending with “Full Employment by Design,” depicted in Figure 8.4, we deal long-term investment decisions in a market economy. The crisis is illustrated with the issues of market malady and fiscal fix in terms of the phases (peak-to- in Figure 8.1, “Market Malady (a Collapse in Investment Demand).” The peak) of the business cycle. The sequence of cause and consequence is tailored collapse is shown in Panel 6 as a leftward shift (from D to D’) in the demand to Keynes’s treatment of business cycles in Chapter 22 of the General Theory, for investment funds. The initial decrease in investment demand is not offset (especially pp. 315ff.) and is offered as being true to Keynes except in one by a corresponding increase in consumption demand. That is, there is no respect. Following modern convention, “cyclical unemployment” and movement along the PPF in Panel 5. Rather, as reduced investment impinges “involuntary unemployment” are treated–for the time being–as synonymous. upon employment and hence income, consumption demand decreases, too. The As already noted, Keynes’s involuntary unemployment consists of both a sudden collapse envisioned by Keynes takes the economy off its PPF. The cyclical and a secular component. And it is the latter component, according to decreases in investment and consumption reinforce one another in multiple him, that has an overriding claim on our attention. Secular unemployment is rounds, eventually resulting in the income-expenditure equilibrium shown in a social tragedy; cyclical unemployment is a complication of secondary Panel 4. This decreased income is accompanied with correspondingly importance. Keynes’s mid-course summing-up chapter (Chapter 18, “The decreased saving, as depicted by the leftward shift (from S to S’) in the supply General Theory of Employment Re-stated,”) puts the two components in of loanable funds. perspective: Consistent with “the outstanding features of our actual experience, The consequences of the sudden collapse, as envisioned by Keynes, square ... we oscillate, avoiding the gravest extremes of fluctuations in employment with simple income-expenditure theory, which gives play to Richard Kahn’s and in prices in both directions, round an intermediate position appreciably multiplier as spelled out by Keynes in his Chapter 10 (pp. 114-122). In Panel below full employment and appreciably above the minimum employment a 6 investment is shown to decrease from $90 to $60. With a marginal decline below which would endanger life” (p. 254). The centrality of secular propensity to consume of 0.6 and hence a spending multiplier of 2.5, this unemployment (associated with the “intermediate position”) as compared to decrease in investment spending of $30 causes income and expenditures to cyclical unemployment (associated with the oscillations) is evidenced by the spiral down by $75 (from $300 to $225), as shown in Panel 4. Panel 5 shows, 176 CYCLICAL UNEMPLOYMENT AND POLICY PRESCRIPTION TIME AND MONEY shifting the supply curve to match the shift in the demand curve, such that the rate of interest remains unchanged. Anticipating this result we did not bother to distinguish between a “decrease in investment” and a “leftward shift in investment demand.” The dominant income effect shows itself on the supply side of the market for loanable funds, effectively robbing the interest rate of its classical role. That is, a movement along the new demand curve that would partially offset the initial reduction of investment is cut short by a shifting of the supply curve. With reductions in both components of output (consumption and investment), the derived demands for labor and for all other inputs fall in strict proportion to one another. Panel 3 shows that the share of income accruing to labor is two thirds both before the sudden collapse and subsequently. As total income falls from $300 to $225, labor income falls from $200 to $150. Panel 1 shows the corresponding leftward shift (from D to D’) of the demand for labor. If the wage rate is sticky downward (as depicted by the unchanged slope in the income-employment relationship in Panel 2), the entire adjustment in income will be made, at least initially, by a proportional adjustment in Figure 8.1: Market Malady (a Collapse in Investment Demand) employment–from 20 to15. The change in N shown in Panel 1 constitutes cyclical unemployment, which, in this construction, is identical to involuntary if somewhat redundantly, that the decrease in income and expenditures takes unemployment. The hollow point in Panel 1 indicates that the going wage is the form of a decrease in investment of $30 and a decrease in consumption of no longer a market-clearing wage. $45. All these aspects of the new “equilibrium” are marked by a hollow point Figure 8.1, then, identifies the initial consequences of a collapse in (in Panel 5) and two solid points (in Panels 4 and 6). The hollow point in Panel investment demand. We have a (Keynesian) income-expenditure equilibrium 5 (C=$165; I=$60) is better described as a point of classical disequilibrium. in Panel 4, market clearing in panel 6, and (classical) disequilibria in Panels Both investment and consumption fall short of the supply-side constraint 1 and 5. Note that these movements away from the initial full-employment imposed by the underlying economic realities. The solid point in Panel 4 position are fully consistent with the Keynesian vision as depicted in Figure (Y=E=$225) marks an equality of income and expenditures that, in Keynesian 7.2. theory, defines macroeconomic equilibrium. The solid point in Panel 6 Figure 8.2, “Locking in the Market Malady (with a Flexible Wage Rate),” (S=$60; I=$60 at an unchanged interest rate) is an equilibrium in a limited helps to put the issue of wage-rate stickiness into perspective. Are sticky wage sense. Given the less-than-full-employment level of income and expenditures, rates critical to our understanding of Keynes’s cyclical unemployment? It may the old rate of interest still clears the market for loanable funds. Note here that seem that any answer to this question gets us into trouble. If we say “Yes,” the applicability of the simple multiplier relationships does not depend upon then the unemployment follows trivially. Our understanding of it does not the particular elasticities–or inelasticies–that characterize the supply and require any special Keynesian insights. The classical economists knew all too demand curves in Panel 6. Rather, it depends upon the multiplier process 177 178 CYCLICAL UNEMPLOYMENT AND POLICY PRESCRIPTION TIME AND MONEY demand for labor is taken to be unit elastic over the relevant range, such that N increased from 15 to 16.7 and labor income remains unchanged (at YN=$150). To the extent that the elasticity actually deviates from unity, second-order adjustments, reflecting the difference between WN and W’N’, would have to be made in Panels 4, 5, and 6. But whatever the elasticity of labor demand (and assuming that labor supply is not perfectly inelastic), the market-clearing wage rate does not restore the full employment depicted in Figure 7.1. The problem of a collapsed investment demand remains, as shown in Panel 6, and the economy is still performing inside the initial PPF, as shown in Panel 5. The stickiness or flexibility of the wage rate, then, is not at all essential to our understanding of the problem identified by Keynes. The behavior of the wage rate has implications only for the particular way that the problem manifests itself–as a very dramatic increase in unemployment at the going wage (in the case of a sticky wage rate) or as a less dramatic increase in unemployment, coupled by a reduction in the wage rate (in the case of flexible wage rate). As a theoretical matter, then, the extent of the wage rate’s Figure 8.2: Locking in the Malady (with a Flexible Wage Rate) flexibility is very much a subsidiary issue. As an empirical matter, the extent of wage-rate flexibility in the 1930s was hardly an issue at all. The massive well that if the wage rate does not adjust to a reduced demand for labor, there unemployment actually experienced during the Great Depression did not will be unemployment. If, allowing for flexible wage rates in both nominal and inspire Keynes to make a fine distinction between dramatic and not-quite-so- real terms, we say “No,” then there would seem to be no dramatic levels of unemployment. As a policy matter, the sticky wage rate, unemployment–cyclical or otherwise–to be understood.
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