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Monetarists had based their theories on the assumption that the equilibrium in the economy rests in the full employment level of national income. There is a demand and supply of labour and market reaches equilibrium where they cross. Short-term fluctuations might exist, and labour might decide (in the presence of benefits, very often)to opt out of employment and be unemployed voluntarily.
Keynes contradicted that view and said that the aggregate demand determines the output of the economy and thus the demand for labour. This has nothing to do with labour supply, as long as the supply is sufficient. In fact a country can be in long-term equilibrium with aggregate demand being insufficient to cause full employment. The classical theory that then the wages would fall and employment increase increasing output and income does not hold as wages are downward sticky. That means people can determine only their monetary wage W not the real wage w=W/Price level(P). But as W is main determinant of P, when W decreases so does P and w is unchanged. The only way to decrease w is by inflation where P increases gradually and sticky W is the same and thus w decreases.
Also labour readily accepts the decline in real wages caused by the rise in P as this affects all workers uniformly, whereas the decline in W would affect only a particular group of workers (wage bargaining is never completely on a national level), so the wage differentials would change after a change in W. Industrial climate and people's attitudes do not favour a change in wage differentials. Workers are caught in a prisoners' dilemma (no one wants to take the first step).
In this essay I am asked to consider first if Keynes had any other arguments besides the downward sticky wages for unemployment. Moreover whether Keynes was right overall in assuming there is any long-term unemployment other than for voluntary and seasonal and frictional (people changing jobs) reasons.
First as I said before Keynes said that main cause of unemployment was the deficiency of aggregate demand. The sticky wages assumption was bought in later to contradict classical view. In short income can be either spend or saved. In low incomes people have negative savings (they use up previous funds) and the marginal propensity to consume (amount of extra income devoted to consumption) remains the same over the range of income. Income must equal to output for the country to be in equilibrium. Output can be either consumption goods, or investment, so:
As seen income(output)= expenditure at Y1, whereas full employment income is at Y*. Unemployment results from too little consumption or investment.
Investment(MEC - marginal efficiency of capital, determines the investment in Keynes) is determined by expectations and interest rates. So ultimately they determine unemployment. When economy is in general downturn and the expectations are low then firms will decrease investment. Also people will save more for rainy days. That will make the C+I curve to shift down and the unemployment will increase. If the interest rate rises due to decreased money supply(Ms) or increased liquidity preference(Md), i.e. people want to hold money then the investment would fall again. So ultimately Ms and Md determine the unemployment too.
The prevailing interest is r1 that leads to investment I1, whereas full employment investment I* could be achieved with the rate r*, so money supply should be increased to Ms*. In downward sticky wages assumption, when country is in equilibrium and the demand for labour (Ld) falls wages will not fall, but instead unemployment occurs:
When Ld falls to Ld1 then instead of new full employment equilibrium wage w1* the old full employment wage persists causing an involuntary unemployment of AB will occur. Note when wage falls to w1* q2q* people will become voluntary unemployed. Friedman has contradicted this view by saying that people will become unemployed because they become fooled by the money wage fall. This unemployment obviously will bring the price level down (in reality decrease inflation) and thus the real wages stay the same and people will accept the lower monetary wage. But again real wage has not changed.
It is somehow complicated to grasp all the influences of a government policy according to Keynesian equations. Reason being that for example following a Ms reduction leading to r reduction and ultimately Y reduction, then that causes a shift in Md curve (less money demanded for transactionary purposes). This in turn causes r to fall even further and so on. Thus an IS-LM model was developed by Hicks to overcome this. It shows the equilibrium values for investment and savings at different GNPs and interest rates. When rates fall, investment is increased and thus to reach equilibrium GDP must increase. Thus IS curve is downward sloping. LM curve shows the equilibrium between money supply and demand. When income rises the GDP will rise causing Md to rise (Ms is constant and does not alter for a single LM curve). Thus LM curve slopes upwards. This can be shown graphically:
Again in here the model does not mean the country is in full employment.
So these were the Keynes' original propositions for the reasons of unemployment other than sticky wages. There are a number of criticism monetarists have made for Keynes' theory calling it "Mr Keynes special theory", that mostly would render the whole idea of sticky wages unplausible. Here we have a small problem, because IS shows flow variables and LM stock variables, so we should find an appropriate time period to equate the curves. I think the solution is easy - interest rate is given for a year, so obviously flow should be taken over a year. Another criticism arises from the fact that the ISLM model uses money wages, not real. It has caused two problems relating to restrictions that could produce unemployment solution.
Modigliani, for example, has investigated the possibility of Ms being too low for full employment at the given rigid money wage. Here the solution is easy for the government just by open market operations to increase Ms.
The other hypothesis had the liquidity preference too high, giving rise to insufficient investment for full employment. This has been eliminated because of the Pigou effect on the propensity of save at low incomes so that S=I at full employment. This in fact is a classical solution to Keynes' problem!
First criticism consists mainly of the initial assumption made by Keynes that the price level is stable. In fact it has been proven that the inflation increases due to Keynesian relaxed fiscal policy. This can cause unemployment, because firms are less certain about their future and invest less. Another feature of demand management is that the voluntary unemployment will increase as people become easy with jobs - they think that the state will take care of it. Also high tax rates imposed because of fiscal expansion can be a disincentive for many people, and they will not work. Thus adverse supply side effects arising from fiscal expansion might be enough to completely offset the beneficial demand side effects.
Parkin has also pointed out that Keynes analysis of labour market will imply a predetermined stock of capital and a variable capital/labour ratio. The former is a short run analysis and the later could imply in long run more often. Furthermore it is more realistic that firms operate with a constant labour/capital ratio. Thus when labour market has excessive wages and there is involuntary unemployment due to too high wages, then the wages could actually fall without an accompanying increase in employment due to firms under-utilising capital. Thus real wage will be between AB in the following diagram:
Keynes theory of labour should also show that the real wages should be rising in recessions as the unemployment rises. The empirical evidence has shown opposite. One explanation to this is that firms operating in a deep recession must cut down their production so their marginal costs(MC) of production are actually falling, so increases in production level reduce price (in perfect competition MC=P). But at these situations firms are actually making a loss(in perfect competition marginal revenue is horizontal), so this situation cannot persist for long.
Further criticisms about the Keynes' MEC curve have arisen because firms should meet increased returns with increased investment, so returns on investment should go up. This is clearly a wrong view as Keynes was talking about marginal investment and not absolute, thus there can be a point where horizontal interest rate will meet rising MEC curve, but the same rate line will meet MEC at a higher investment, meanwhile the marginal investments producing profits:
Critics say a firm should be at A, but then it would be making a lost on the investment. Keynes would say they go to B. He had drawn, for this loss making reasons, MEC curve only for levels above I1.
As seen the debate is still complicated and unfinished. Mainly the argument has turned to the fact whether the wage will fall sufficiently for people to give up their work voluntarily or not. Putting it that way - it should not matter. But when wage falls firms could also expand employment (although not by the full extent of involuntary unemployment at previous wage because of the downward sloping Ld curve) and thus increase GDP permanently and produce Pareto efficiently. Original formulation set by Keynes definitely needs some modifications (ISLM) to be analysed better, and there is definitely some efficiency lost due to established wage differentials in the short-run. But whether they are very significant or persist in the long-run still remains a question.