Question

Do you agree with the proposition that downward stickiness in money wages is the only reason for the existence of involuntary unemployment in Keynes’s model? If not, what are the other obstacles to the self-righting property of the market economy, and explain their implications for the aggregate demand curve as well as the working of the Keynes’s model under the assumption that money wages are flexible. Elaborate your answer using IS-LM, AD-AS and labor market curves.

Answer 1

Downward stickiness in money wages is not the only reason for the existence of involuntary unemployment in Keynes’s model. However, it is an important factor.

The other very important factor is "animal spirits" in the economy. It basically means that if an economy has poor animal spirits i.e bad business sentiments, then its investment falls and hence the income falls. However an economy with good animal spirits i.e good business sentiments, then its investment increases and hence the income goes up. As the income of the people change, they change their demand for goods and services and it keeps the economy going. Keynes asserted that the economy can not revive from a downturn mainly because animal spirits are poor, firms lay-off more wokers, and on worker's side because they do not take a fall in money wages, they tend to be jobless.

Note that the keynesian model was a short-run model,, so there is no change in prices.

IS-LM model:

IS shows the equilibrium in goods market and is defined as C+I+G where C= consumption, I= Investments, G= government expenditure. With bad animal spirits, as investments falls, there is a leftward shift in IS curve. There is a fall in income from Y1 to Y2.

AD-AS model:

In pure keynesian model, AS is horizontal to x-axis because keynes assumed in the short-run, at given price any amount of supply is possible because economy has not reached full employment output. Because of low income, AD falls and there is a corresponding fall in output.

Labor market:

As there is a fall in investments by firms, labor demand falls and the curve shifts to left. Even if money wages are allowed to fall ( as shown from W1 to W2 in the diagram), there is now lesser demand for workers at L2, and the economy achieves underemployment equilibrium.

The keynesian solution of active public expenditure to revive the economy out of downturn holds true.