Keynesian Involuntary Unemployment and Sticky Nominal Wages

Abstract

This paper presents a model in which sticky nominal wages and Keynesian involuntary unemployment result as a consequence of the intertemporal optimisation decisions of profit maximising monopsonistic firms and fully rational and informed workers in an uncertain environment. Uncertainty associated with the business cycle and its impact on product price generates disequilibrium wages and identifies the labour demand function in contractions and the supply of labour in expansions. The theoretical prediction of a negative relationship between real wages and employment during contractions and a positive relationship during expansions is strongly supported by the empirical evidence presented. Central to Keynesian macroeconomics is the concept of involuntary unemployment, the existence of which once was a commonly agreed upon stylised fact. However, as noted by Hoover (i988) and McCafferty (i990) among others, existing models either fail to provide a satisfactory reason why wages do not adjust to clear the market or seek some sort of equilibrium explanation in which unemployment is not strictly involuntary in the sense of Keynes. Moreover, the failure of recent empirical studies to support the Keynesian prediction of a countercyclical wage has led some to doubt the relevance of Keynesian economics and even the meaningfulness of the notion of involuntary unemployment (Lucas, 1978; Farmer, 1993) . Keynes (I 939) cited findings of a countercyclical real wage during the Great Depression, argued that the relationship between real wages and employment depends upon whether changes in employment are due to changes in effective demand or due to other factors, and recommended that observations on real wages ought to be classified by periods of contraction and expansion. An examination of US data for the period 1920-89, presented in Section II of this paper, confirms the importance of Keynes's argument and motivated the development of the new Keynesian model of employment and wages presented in Section III. The model is characterised by a market structure in which representative monopsonistic firms post nominal wage rates (which they may find optimal to partially but not totally index) in advance of knowing product price and of hiring labourers (who may have complete knowledge relevant to their choices). Price forecasts are assumed to be rational while prices vary with the state of the economy. The theoretical framework (i) incorporates all of the characteristics of Keynesian involuntary unemployment while not attributing the cause of unemployment to the supply behaviours of labourers, (2) provides an explanation of why wages do not adjust to clear the market that is based explicitly on the optimising behaviour of firms (and implicitly on that of