Keynes’ Rejection of Wage Rigidity

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This post addresses a long-standing curiosity in macroeconomics that is especially relevant to the GEM Project. Why did Keynes reject a role for nominal wage rigidity (WR) in his explanation of involuntary job loss? From The General Theory (1936): “There is therefore no ground for the belief that a flexible wage policy is capable of maintaining a state of continuous full employment…. The economic system cannot be made self-adjusting along these lines.” It should, of course, be noted upfront that Keynes’ rejection was always made suspicious by his critical use of WR in his actual modeling of mass unemployment.

In what follows, the GEM Project’s generalization of rational exchange from the marketplace to information-challenged workplaces helps make sense out of Keynes’ attempt to understand involuntary job loss (IJL) absent WR. The story turns on two central objectives of the great theorist in the propagation his macro revolution. First, he very much wanted his new theory to preserve the classical infrastructure of general market equilibrium. Second, he wanted to steer clear of wage cutting as a policy response to mass IJL.

Given those objectives, Keynes’ WR snub is ultimately rooted in the nature of economic theory when he wrote The General Theory. Simply put, he lacked analytic tools sufficient to rationally model IJL. From De Vroey (2016): “Keynes could simply accomplish no more than what was possible given the state of economic theory at the time. The program he pursued was extremely ambitious, more than he realized, and he lacked the means to achieve it….  In other words, he perceived that involuntary unemployment should be accounted for in general equilibrium terms (although he did not use this expression); but its origin had to be sought in other parts of the economy than the labor market.”

The GEM Project, with its focus on employer-employee exchange that rationally occurs outside the labor market, comes to the rescue. Adding the workplace venue of optimizing exchange to mainstream market-centric analysis moves debate beyond the General Theory’s rejection of wage rigidity. The dual-venue model derives powerful WR consistent with the neoclassical tenets of optimization and equilibrium. It also eliminates nominal wage-cutting as a plausible policy for reducing involuntary job loss. The workplace-marketplace synthesis at last provides a general theory that features the discretionary management of aggregate demand and is rooted in rational downward wage rigidity and chronic wage rent, ratifying Modigliani’s intuition about the macro centrality of WR.

Putting it altogether, four interrelated characteristics of generalized-exchange modeling have combined to solve The General Theory’s wage-rigidity dilemma. First, and most critically, it firmly places involuntary job loss that occurs in response to adverse nominal demand disturbances in the neoclassical context of optimization and equilibrium.

Second, the intrafirm venue of rational exchange provides the tools needed to construct stabilization-relevant macro theory. In particular, the workplace-marketplace synthesis is the long sought-after general theory that ratifies the Early Keynesian choice to assign analytic centrality to wage rigidity. Third, The dual theory locates IJL in large, highly specialized firms – consistent with the evidence as well as Keynes’ intuition. Finally, the workplace-marketplace synthesis identifies the stabilization centrality of discretionary aggregate-demand management.

Blog Type: The General Theory

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