Keynesian macroeconomics argues that low spending causes unemployment.  This problem is reflected in the labor market;  the number of people who want jobs at prevailing wages (labor supply) exceeds the number of people firms are willing to hire (labor demand).  The simplest of economic models suggests that when supply exceeds demand the price in that market will fall; in the labor market this means that wages fall.  If one looks at the labor market in isolation, it seems intuitive that falling wages should encourage employers to hire more workers.  In addition, if wages fall, firms’ production costs will decline.  This could induce competitive firms to reduce their prices and possibly encouraging their customers to buy more goods and services.  The implication seems to be that lower wages and prices could solve the problem of unemployment and insufficient demand.

This perspective is widely shared among macroeconomists.  Indeed the most widespread interpretation of Keynesian macroeconomics is that the theory only applies when wages or prices are somehow “sticky.”  That is, they do not decline fast enough when demand declines.

This interpretation has an important implication:  Keynesian unemployment due to low demand could be just temporary.  Once wages and prices fully adjust, the economy returns to full employment.  This perspective is widely known as the “neoclassical synthesis.”  According to this school of thought, insufficient demand problems are confined to the “short run.”  In the “long run,” involuntary unemployment disappears and the economy approaches full employment and potential output.  In this sense, the neoclassical synthesis bridges the gap between Keynesian and classical macroeconomics. 

Origins of the Neoclassical Synthesis
The term “Neoclassical Synthesis” was coined by Paul Samuelson, a Nobel Prize winning economist.  Samuelson first used the phrase in the 1955 edition of his textbook, Foundations of Economic Analysis, which sold over 4 million copies, making it the most widely used economics textbook in history.  The neoclassical synthesis uses Keynesian theory to explain short-term phenomena while returning to a Classical full-employment model to analyze long-term economic performance.  While Samuelson introduced the term, the logical concepts that underlie the logic of the synthesis were also developed by other economists in the post World War II years, especially the Nobel laureates John Hicks and Franco Modigliani.

The paragraphs below assess these ideas.  We agree that sticky wages or prices can cause Keynesian involuntary unemployment.  We question, however, that falling wages and prices actually push the economy back to full employment.   In this case, the neoclassical synthesis fails, and we cannot assume that problems of insufficient demand to generate full employment are temporary. 

Unemployment, Wages, and Prices: How the Neoclassical Synthesis Works

It may be intuitive to assume that lower wages by themselves should raise employment.  But if the initial problem is low demand, this outcome is highly unlikely.  The reason for unemployment is not that wages are too high.  Rather, the problem is insufficient sales.  Clearly wages that are lower throughout the entire economy will not encourage workers to buy more.  They may imply higher profits for the firm, but because profits tend to flow to higher income people, it seems very unlikely that new spending out of higher profits would offset spending reductions due to lower wages. Therefore, if there is any direct effect of lower wages on demand, it is most likely to be negative, magnifying the unemployment problem.

What about the effect on prices?  The lower wage level reduces the cost to produce for firms.  Consequently, competition among firms could induce them to cut their prices.  Do lower prices stimulate demand for goods and services?  It might seem obvious that the answer is yes.  After all, the idea that lower prices induce more demand (that is, demand curves slope downward) is about as basic a proposition as there is in introductory economics.  But macroeconomists have long recognized that the simple link between prices and demand in individual markets need not apply to the economy as a whole.  For example, consider why the demand for apples rises when the price of apples falls.  Apples become cheaper relative to oranges and people buy more apples and fewer oranges.  But if the prices of everything fall, there is no obvious channel for this kind of substitution.  Also, if prices decline, in general, money incomes must fall too, since what one person pays determines someone else’s income.

The previous two paragraphs show that simple microeconomic analysis does not justify the assumption that falling wages or prices directly raise aggregate demand or employment.  Textbooks have long recognized this point.  The justification for the key neoclassical synthesis assertion that wage and price adjustment assure enough demand to purchase potential output has always relied on indirect effects. 

Income & Substitution Effects
We have seen that the parallel between a single market or household and the entire economy can be misleading.  In particular, consumers may respond to a price change in a single market differently than they would respond to falling prices throughout the economy.  Consumer reactions to price changes can be broken down into two different parts, the income and substitution effects.  In order to learn more about how these effects work and why deflation (falling prices) may not increase consumption, click here.

Unemployment pushes wages down and lower wages lead to lower prices.  Lower prices could induce demand to rise through two channels.  First, when prices fall, individuals can buy more with the money in their pockets. Even though wage incomes are lower, some people might buy more because the purchasing power of money they accumulated goes up.  Economists call this channel a “wealth effect” because it represents additional spending induced by the higher purchasing power of one part of household wealth, the stock of money.   Second, when the purchasing power of the economy’s money stock rises, people need less money to finance their day-to-day transactions.  The demand for holding money goes down, which lowers the “price” of money, that is, the interest rate falls.  A lower interest rate reduces the reward for saving, encouraging households to spend more.  It also makes loans cheaper which can encourage more borrowing by households and firms that leads to spending. 

When prices drop across the economy, the purchasing power of each dollar increases.  Any savings a person is holding at the time thus increase in value: individuals experience a “wealth effect.”  On the other hand, their flow of income falls due to falling prices, so they do not experience an “income effect.”  Importantly, while an income effect would continue to work over time, a wealth effect occurs one time, immediately (and as such is likely rather small). 

Income Effect vs. Wealth Effect
It is important to distinguish between an “income effect” and a “wealth effect.”  While income is a flow (the rate of change over time), wealth is stock (a fixed quantity at any one point in time).  Wealth, then, is the fixed amount of money one holds at a given point in time; income is the amount that the stock of wealth changes over a fixed period of time (e.g. a year or a quarter).  When prices drop across the economy, the purchasing power of each dollar increases.  Any savings a person is holding at the time thus increase in value: individuals experience a “wealth effect.”  On the other hand, their flow of income falls due to falling prices, so they do not experience an “income effect.”  Importantly, while an income effect would continue to work over time, a wealth effect occurs one time, immediately.

These wealth effect and interest rate channels are stabilizing, because they tend to restore aggregate demand after some downward movement of demand-caused unemployment—a stabilizing result for the economy.  In the absence of any other disturbance, this adjustment process continues as long as unemployment continues to put downward pressure on wages; that is, until aggregate demand is restored to a level that supports full employment and any unused resources are put to work again. 

How long will it take for this desirable process to do its work?  The answer depends on how quickly wages respond to unemployment and how fast prices respond to changes in wages.  Therefore the degree of wage and price “stickiness” determines the time frame over which demand constraints cause unemployment.

This theory leads to results accepted by most mainstream macroeconomists:  demand shortages can cause Keynesian unemployment over some horizon until wages and prices fully adjust, but in the long run economic growth is driven by the “supply side,” the evolution of technology and resources.  Recessions should therefore be temporary interruptions of the long-run, supply-driven growth trend.  The theory is enshrined in generations of macro textbooks.  But according to our MWM perspective, this neoclassical synthesis perspective does not account for important aspects of reality, as we now discuss.

Destabilizing Effects of Deflation

While the wage-price adjustment theory may at first appear convincing, the typical analysis ignores other channels through which falling wages and prices affect demand.  A more realistic and complete account shows that wage and price adjustment is unlikely to solve the problem of insufficient demand.  Indeed, widespread deflation may well make Keynesian demand problems worse.

The key problem is that some effects of declining wages and prices depress demand, that is, there are destabilizing channels that mitigate or even completely reverse the effect of the stabilizing channels discussed in the previous section. 

Deflation and Disinflation
This discussion analyzes the effect of falling prices, that is, deflation.  Similar  points can be made about disinflation, a decline in the rate of inflation (for example, inflation falls from 3% to 2%).  In disinflation, prices rise more slowly but they do not literally decline.  Disinflation can have destabilizing effects as well, especially if prices rise more slowly than borrowers anticipated when they signed their debt contracts.  In particular, the interest rate on debts in purchasing power terms (often called the “real” interest rate) will be higher than people expected if inflation turns out to be lower than they expected when they entered into debt contracts.

One destabilizing channel centers on the relationship between deflation and indebtedness.  If wages and prices fall, incomes decline throughout the economy.  But people owe the same amount in debts that they contracted earlier when incomes were higher.  Repayment becomes more difficult.  This may cause debtors to “tighten their belts” in an effort to keep up with their debt payments.  Lenders may also be less likely to extend further credit as they worry more about repayment risk.  More frugal borrowers and more stingy lenders lead to lower spending. These considerations suggest that demand could be depressed further by falling wages and prices, the opposite of what is suggested by the neoclassical synthesis. 

Another destabilizing channel arises from the redistribution of wealth following deflation.  When prices fall, purchasing power is distributed from borrowers (because they now owe more in purchasing power) to lenders (whose repayments are now worth more in purchasing power).  Because this is a redistribution from one group to another, one might think that it has no macroeconomic effect.  But borrowers as a group became borrowers because they tend to be high spenders while lenders tend to be low spenders.  For this reason, falling prices that redistribute purchasing power from borrowers to lenders will most likely reduce aggregate spending and, again, create a destabilizing channel for deflation. 

A final destabilizing channel centers on consumer expectations.  Declining prices today may induce individuals to expect prices to fall even further in the future.  If you think prices will be lower in the future, it makes sense to defer spending. 

Home Prices, Expectations, & Demand
Real estate prices declined dramatically from mid 2007 through mid 2009.  Spending on new homes also collapsed during this period, and remained historically low for years into the recovery.  It seems likely that potential homebuyers’ fear of further price declines reduced the demand for homes.  This example supports the idea that the expectation of falling prices encourages people to defer purchases.

Will Falling Wages and Prices Cure Unemployment?

Once both stabilizing and destabilizing channels are considered, the net effect of lower wages and prices on demand is ambiguous.  To determine which effect dominates, one must look at empirical evidence.  In the current U.S. economic environment, deflation is most likely to be destabilizing.  Why?  The most important factor is the high burden of household debt.  Modest inflation, especially in wages, reduces the burden of debt (because wage growth increases the money income available to service debt) while deflation makes the debt more burdensome and increases the chances of default. 

Deflation in the Great Depression of the 1930s (overall prices fell more than 25 percent from 1930 through 1933) seemed to magnify the extreme financial instability of those difficult times.  Japan has experienced mild deflation during a long stagnant period beginning in the early 1990s, yet a robust Japanese recovery remains elusive.  These experiences seem to have affected modern central banking.  Both Alan Greenspan and Ben Bernanke have been determined to avoid deflation, largely because they recognize its destabilizing effects on the financial system.

Our MWM perspective on this issue, therefore, is that falling wages and prices are not an effective cure for unemployment caused by insufficient wages.  One cannot look at the labor market in isolation and assert that lower wages will raise employment.  One cannot argue that lower prices of goods and services will simply raise demand by looking at the output market alone.  Macroeconomics requires consideration of interactions between different parts of the economy.  In a modern, financially sophisticated economic system with extensive debt contracts, we argue that declining wages and prices in the face of unemployment are more likely to cause harm than they are to push the economy toward full employment.

Does Keynesian Macroeconomics Require Sticky Prices?
The textbook treatment of Keynesian theory often asserts that demand can constrain the economy only as long as wages and prices fail to adjust fully to a level that raises demand back to potential output.  In this interpretation, Keynesian macro becomes equivalent to the macroeconomic implications of rigid wages and/or prices.  But the MWM perspective argues that deflation or disinflation will not reliably increase demand to full employment levels.  Therefore, demand constraints and the potential for Keynesian unemployment are not due to sticky prices only.  Demand problems are inherent to modern economies and their impact can persist indefinitely.

Key Points

  • Unemployment will likely cause wages to decline.  Lower wages reduce costs and encourage firms to reduce prices.
  • Many economists subscribe to the “neoclassical synthesis” that bridges classical and Keynesian macroeconomics: falling prices will eventually boost demand until unemployment is eliminated.  If this is the case, demand only constrains the economy in the “short run” until wages and prices fully adjust.  Supply alone determines the long run path of the economy.
  • In contrast, we argue that destabilizing channels through which lower prices reduce demand are important.  These effects are probably large enough that flexible wages and prices cannot solve the demand problem in modern economies.  Demand constraints can have a persistent impact and unemployment may not be just a short-term problem.

Please proceed to the final “basics” page: The MWM Perspective on Macroeconomics.