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Page 1: The Keynesians-Classics Controversy: A Re-Interpretation

The Keynesians-Classics Controversy: A Re-Interpretation

By F. VAN DEN BOGAERDE

1. The Formal Comparison of Keynesian with Classical EconomicsEVER SINCE the publication of the General Theory and Sir John Hicks' almost equally famous article it has been fashionable andindeed necessary to contrast Keynes with the Classics. For this is the only way to understand the nature of full employment asagainst less than full employment equilibrium.It has become equally fashionable to present theory in the convenient shorthand of a set of equations or "model". Thus it hasbecome customary to contrast Keynesian with Classical theory by presenting them in the form of two models and pointing out thesignificant differences between them.*(1) An example of such a comparison is given in Table 1.TABLE 1

1. "Keynesian" 2. Classical

1.1 S = fs(Q) 2.1 S = fs(r)

1.2 I = f1(r) 2.2 I = f1(r)

1.3 I = S 2.3 I = S

1.4 M = kY + fm(r) 2.4 M = kY

1.5 Y = pQ 2.5 Y = pQ

1.6 Q = f(N) 2.6 Q = f(N)

1.7 W = + f(N) 2.7 N = f

1.8 2.8

The equations on the right represent Classical theory, whereas those on the left represent a Keynesian system. Both modelscontain eight simultaneous equations in eight endogenous variables: S, savings; I, investment; Q real output; Y, income in terms ofcurrent prices; r, the rate of interest; p, the general price level; w, the money wage rate and N, the level of employment. M is thequantity of money given as an exogenous variable; k is a parameter indicating the demand for transaction money; is a given levelof the money wage below which w cannot fall; it occurs only in the Keynesian system.

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The equations are easily recognised as: (1) a savings function, (2) an investment function, (3) an equilibrium condition on thegoods-market and (4) a monetary equilibrium condition; (1.1) to (1.4) on the "Keynesian" side would give the IS-LM system. Theequation in the 5th line defines income at current prices; (6) is a (neo-classical) production function with capital a fixed factor notexplicitly shown; (7) represents the supply of labour and (8) is the maximum profit equation.It shows that marginal output must equal the real wage and for this reason it is often, indeed usually, called the demand forlabour.*(2)The differences between the two theories are then identified by pointing out the differences occurring in lines (1), (4) and (7). Theequations at (1) show that Keynes would stress (real) income as the determinant of savings (or consumption) whereas in Classicaltheory it would be the rate of interest. Monetary equilibrium at (1.4) would show a speculative demand for money, fm(r) whereas theClassical M = kY = kpQ is a wellknown version of the quantity theory. Finally (1.7) would show the Keynesian supply of labour tobe a function of a downwardly rigid money wage (w), whereas labour supply in the Classical model would refer to the real wage*(3).The purpose of pointing out these differences is to show how the Keynesian model does and the Classical model does not allow anequilibrium to occur at income levels falling below full employment. But one question is asked next and sometimes in almostidentical terms: which of the three differences is the "crucial" one?*(4) Naturally opinions differ on this. Thus Allen would say thatall three are important; Ackley is inclined to favour no.1. Yet another point of view is "that the difference between the Keynesianresults and those obtained by what he called 'classical' economics cannot be reduced merely to different assumptions or to someadditional behavioral equations".*(5) The difference between the two systems should therefore be considered to be far more basicthan is supposed in mentioning the three points summarised above. This essay is an attempt to study this statement further.

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It is likely that Blaug's statement is, at least partly, inspired by a consideration which is equally obvious: the striking similarity ofthe two models. Five out of the eight pairs of equations are identical. But even more important is the fact that in both modelsexactly the same variables occur. The theories behind both models

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give a solution for the determination of real income or product (Q), the level of employment (N), the rate of interest (r), the moneywage (w) as well as the absolute price level (p). It is perfectly true, of course, that a formal model hides a multitude of sins so thateven very small variations in an equation may show a completely different theory. One should therefore approach this matter withgreat care

2. The Working of the Old Classical ModelAs well known as the three differences between the "Keynesian" and Classical models mentioned in the previous section is thefact that the former cannot and the latter can be split up into different parts.*(6)Employment (N) and real output (Q) are determined by the classical equations (2.6), (2.7) and (2.8). This also determines the wageprice ratio or real wage .The known level of Q will determine the general price level (p) by way of the quantity theory (2.4) and the definitional equation(2.5). Since the real wage was known the money wage is determined as well. Then, quite independently from the price level, the rateof interest determines the division of total output between consumption and investment (2.1), (2.2) and (2.3).The important point about this decomposition of the classical model would seem to be that the labour market is at the centre of thisanalysis, i.e. of the classical theory of income and employment. Moreover, although this is a market for the economy as a whole, sothat its analysis belongs to macroeconomics, the method of analysis is strictly microeconomic.In microeconomics the price problem is solved by means of supply and demand curves (in perfect competition). If the price is toolow then excess demand will pull prices up until the amount supplied equals the amount demanded; if price is too high then excesssupply will push the price down until again it is at the level determined by the intersection of the supply and demand curves. Thisrule applies to the markets of goods as well as the markets of productive services. The behaviour of firms is determined by themaximum profit condition. As far as the goods market is concerned this means that marginal cost is set equal to marginal revenue(equals price in perfect competition). The rule has its exact counterpart on the market for factor services; the employer hires variablefactors in such a way that marginal revenue product equals the price of the factor. The marginal revenue product (MRP) curve thusrepresents the demand for a variable factor. Since MRP = p x MO (MO is marginal output) the marginal output curve wouldrepresent factor demand in real terms. This is also the essence of the marginal productivity theory according to which factor pricewill tend to equal marginal output, for this is the content of the maximum profit condition.Now micro-economics is by definition partial equilibrium analysis and one is, therefore, entitled to disregard repercussions on othermarkets by way of a ceteris paribus clause. However macro-analysis is different. Therefore, if one considers the

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labour market for an economy as a whole one must take further repercussions into account.To see what this means it is necessary to look at panel (3) of fig. 1. In this diagram Ns is the supply curve of labour, supply taken asa function of the real wage.*(7) ND is the marginal output curve which at intersection F shows the maximum profit condition.According to the old classical theory the maximum profit condition would cause employment to stabilise at Nf with the real wage at. And just as in micro-theory this would have to mean that the marginal output curve ND is the demand curve for labour. Forinstance, if the real wage were , there would be an excess demand for labour. Employers would actually attempt to employ N2workers. Since only N1 are available they would offer higher money wages thus raising real wages to .On the other hand, if the real wage were , employers would not be willing to employ more than N1 workers. There would be anexcess supply of labour KL. This would cause money and therefore real wages to fall. Since ND is a demand curve the amount oflabour demanded would rise from N1 until eventually Nf was reached; in other words full employment would again be achieved.The next point is well known: if trade unions were to succeed in keeping the real wage level at then it would be impossible to returnto full employment and the policy prescription would have to be to allow real wages to fall.*(8) According to old or palaeo-classicaltheory an important cause of unemployment would, there-fore, be excessive real wages.All this seems straightforward enough, but it is not, for repercussions on other markets have not been mentioned. Again taking areal wage as one's point of departure it has already been seen that, according to the production function in panel (2) of fig. 1output would be at Q1. If ND is the demand curve for labour then a fall in means an increase in employment and hence an increasein output.

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FIG. 1.However, the question now arises whether a larger output can be sold on the goods market. One would expect that, if it cannot,then employers would not be willing to employ more than N1 labour units: for profits will only be higher at employment Nf than atN1 provided Qf can actually be sold on the goods market.*(9)In palaeo-classical theory this is no problem, for demand on the goods market is subject to Say's Law. If supply creates its owndemand, then an increase in output from Q1 to say, Qf is automatically accompanied by an increase in the amount

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demanded on the goods market. That this is so is ensured in the Classical model by the absence of Q in the savings equation andof speculative balances in the money equation.The interesting point about this is that if the marginal output curve ND is considered to be the demand curve for labour this mustimply the acceptance of Say's Law. For a demand curve for labour shows varying amounts of labour that would be bought atdifferent levels of the real wage rate. But this would be so only if there are no complications from the side of the goods market andthese are only removed by accepting Say's Law.But if this is so, the question is how the marginal output curve, which in table 1 occurs in both the "Keynesian" and the classicalmodel should be interpreted. This interpretation will now follow.

3. Income Demand versus Price DemandWe saw in the previous section that the old classical theory of income and employment was expressed in the familiar terms ofmicro-economic price theory. Thus the marginal output curve ND was treated as any price demand curve. In a way this can beregarded as a brilliant tour de force since the theory by using Say's Law and the quantity theory could avoid almost any referenceto income demand. So persuasive was the old classical theory that even today the marginal output curve is still called the demandfor labour.However, macroeconomics was and is in the first place a theory of income and employment. In principle this should mean thatequilibrium is not in the first place determined by the price level at which the amount supplied equals the amount demanded;equilibrium should be determined by the level of income (= output) at which the amount demanded equals output. In contrast to theassumptions of the old classical theory, income demand is not necessarily equal to output at each and every level of output, asSay's Law would have it.The basic difference between the old classical model as in table 1 and the more modern approach of both Keynesian andneo-classical theory would, therefore, seem to be that the latter two stress the income demand for goods, whereas the formerstressed the price demand for labour. In the old classical theory 3/4 when looking at table 1 3/4 one would concentrate on thelower three equations; in 20th century macro-theory one takes the top four equations as one's point of departure.*(10)It is often maintained that of the three differences between Keynes and the Classics the "crucial" one is shown in the first line intable 1. Keynes is, after all, the inventor of the consumption function and its corollary the propensity to consume. Theconsumption function is, of course, an element 3/4 be it a very important one 3/4 in aggregate income demand for output. Anotherelement is investment, even if it is shown as independent of income as such as in table 1. Looking at it in this way it is unlikely thatKeynes should be credited to the extent claimed, for income demand was not a concept unknown to economists such as Wickselland especially Pigou.

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Perhaps it would not be altogether unfair to say that Keynes, taking income demand as his point of departure, was true to theneo-classical tradition even if the issue was obfuscated by his particular approach. There is no difference in this respect betweenKeynesian and neo-classical theory. This means that in table 1 the classical model is, in fact, the old classical model which shouldbe discarded in trying to compare the two sets of theories. This is so even if in the end it can be shown that the solution of the oldand new classical models (full employment output) are substantially the same. What we must show is that the "Keynesian" modelin table 1 is not a true reflection of Keynesian theory. We return to fig. 1 which must now be studied as a whole.The first panel of fig. 1 contains the wellknown IS-LM curves in real terms (Q is measured horizontally); this panel is based on thefirst four equations in the "Keynesian" model in table 1 (i.e. (1.1), (1.2), (1.3) and (1.4)). Panel (2) in the diagram (to the right andplaced centrally) shows the production function (neo-classical with variable proportions). If the amount demanded, as determinedby equilibrium on the goods and money markets, is known then the number of labour units required can be read off in no. (2). Thethird panel has, in a way, been discussed already. NS is the supply curve of labour, showing at what price (the real wage) differentamounts of labour can be hired. ND is the marginal output curve showing the (decreasing, but positive) slope of the productionfunction. The two curves afford the possibility of comparing for each level of employment the value of MO with the real wage.*(11)

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The curve ND is the marginal output curve, no more and no less. It is not the demand curve for labour because the amountdemanded of labour is determined by the income demand for goods, via the production function; clearly the demand for labour is aderived demand. But although ND is no longer the labour demand curve, its intersection F with NS and the level of employment Nfstill determines full employment at the real wage level . More labour units than Nf cannot be employed because this would meanthat MO falls below the real wage level that must be paid to secure this amount of labour. This would decrease profit below what itwould be at Nf. Even if the demand for goods would indicate a higher level of employment it must be assumed that employers arefree not to produce this much, if N would have to be beyond Nf. In point of fact this is how ND will be treated from now on: as apossible restriction on supply.*(12)

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Now to explain further we take the situation where equilibria on the goods market are indicated by IS1 and money market equilibriaby LM. This would mean that income demand and the rate of interest determine the amount of output demanded at the level Qf.According to the right hand panel this requires Nf units of labour. The question is whether Nf will be employed so that Qf will alsobe supplied, for this must be the requirement for equilibrium.Now on the basis of what was said just now employers would employ Nf provided they would not be better off by employing lessthan Nf; in other words, provided that at employment Nf (= MO) does not fall below the real wage to be paid. The IS and LMcurves have purposely been chosen in such a way that this is not the case. As a matter of fact Nf coincides with full employmentas defined above. Furthermore at F : so that employers are earning maximum possible profits; in other words the maximum profitcondition is also complied with.It may be mentioned parenthetically that although this is a full employment equilibrium, it does not fall outside the Keynesianframework of reference. Keynesian theory does not exclude the possibility of full employment, even if it does imply that otherequilibria are possible as well. Let us now look at such an equilibrium.Suppose there is a decrease in one of the autonomous components of aggregate demand which shifts the goods market equilibriumcurve from IS1 to IS2. Now it can be mentioned that in the old classical theory, even if such a change could take place, it would notaffect the amount of output demanded. For if there were no passive funds, the IS curves would intersect an LM curve in itsperfectly inelastic part (the so-called "classical range"). In other words LM would coincide with A'Af. The rate of interest woulddrop but the intersection of IS2 with this LM curve would still determine demand at Qf.However, in the diagram, IS, and IS2 intersect LM in the "intermediate range". This means that there are, in fact, passive fundsbeing held, and that more will be held when there is a drop in the rate of interest. The LM curve is based on an equation such as(1.4) and although this is in contrast with the old classical theory (cf. table 1) it is not in contrast with neo-classical theory whichcan accommodate a demand for passive funds. The second difference between Keynes and the Classics would, therefore, as thefirst one, seem to be of no great importance either. For accepting a J-shaped LM curve does not exclude a move back towards fullemployment equilibrium.In the event, the change in IS means a drop in real demand from Qf to Q1; this requires the employment of N1 units of labourinstead of Nf. If it can be shown that with real demand at Qf only Qf will be supplied, so that employment is at N1, then this wouldseem to be a clear and obvious case of Keynesian unemployment caused by a demand deficiency.

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Suppose that, to begin with, one works with a period of very limited duration such as Marshall's short term or market period andthat one assumes that in this period no change will occur in either the money wage or the price level established in the previous fullemployment situation. This means, of course that the real wage will stay at the level compatible with full employment .It was already explained that firms would achieve maximum profit by employing Nf units of labour at the real wage . In the oldclassical system they would proceed to do just this and this is precisely where the Keynesian and neo-classical models differ fromthe palaeo-classical model. In the modern models we start with demand. Demand was at Q1, as mentioned a moment ago. No morethan Q1 can be sold. Employers may wish they could employ Nf, but since they cannot sell more than Q1 they would be unwise toemploy more than N1. All they would achieve is to build up inventories.Earlier on it was said that employers would take on a certain number of workers provided they would not be better off by employingless; this would depend on whether at the relevant level of employment marginal output was less than the real wage or not. Thediagram shows that with employment at N1 marginal output, according to ND, is N1K and this is more than .But this means that the maximum profit condition does not apply 3/4 this is obvious at any rate for this condition applies only at F.Nevertheless it can be stated that by employing N1, employers are doing the best they can; they are earning the highest profitwithin the restrictions posed by demand. In other words by employing N1 units of labour at the real wage , they are complying withwhat could be called the maximum profit principle. The maximum profit principle is adhered to by employers when they attempt toget as close as possible to the maximum profit condition, in other words they do the best they can in the circumstances. In a formal

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way the maximum profit principle could be expressed as follows:

or: the real wage must not exceed marginal output. This is an important result that we shall refer to again. It also shows the new roleassigned to what thus far was often called labour demand.*(13)There is a further interesting point which the diagram shows clearly once the maximum profit principle is acknowledged. Withdemand at Q1 it makes no difference to the amount of goods supplied whether the real wage is at or the much lower level ; both arecompatible with employment N1. This is in sharp contrast to the situation when demand is at Qf, for this cannot be producedunless

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the real wage is exactly at . Thus with underemployment the real wage rate would be indeterminate and this applies also to the pricelevel and the money wage. Presently we shall return to the situation where the real wage is constant. However, we must first studysome of the further effects of an underemployment equilibrium. Two things may happen either by themselves or in combination: afall in the money wage and a fall in the price level; this in its turn must affect the real wage level. The effect of these changes on thelabour market will be called primary effects; their effect on the demand for goods will be called secondary effects.

4. The Effect of a Decrease in the Money WageThe decrease in demand from Qf to Q1 causes a decrease in employment from Nf to N1 and, as long as the real wage remains atunemployment will equal the difference between Nf and N1. The appearance of unemployment can be interpreted as the appearanceof excess supply on the labour market and it is not inconceivable that this may lead to a fall in money wages. If the price level isassumed to remain constant for the moment, this would mean a proportional drop in real wages.The lower panel of fig. 1 (no. 3) shows that the real wage level cannot fall below . If the money wage level were to fall to such anextent that the real wage dropped to, say, one would be justified in claiming that there is an excess demand for labour. For with thereal demand for goods at Q1 employers wish to employ N1 workers. At no more than N0 would be forthcoming and so employerswould bid up the money wage until = N1C. As a matter of fact with goods demand at Q1 one can say that labour demand will runalong NDK N1.Now this drop in the real wage to seems to reflect what is usually considered to be the reaction of wages to unemploymentaccording to classical theory. According to most interpretations of the classics wages would fall without limit and this wouldeventually solve the unemployment problem.*(14) In point of fact at the real wage the unemployment problem has been solvedafter a fashion. The real wage is now so low that only N1 labour units are supplied on the market, but the absence of unemploymentdoes not in this case mean full employment. At any rate, in terms of the models we have discussed, we are now even further awayfrom the maximum profit condition than at the wage level .It is clear at once that the fall in the money wage (which also lowers the real wage) has no direct effect on the labour market. Butsince the meaning of ND has

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been more clearly explained this comes as no surprise, for one must first determine how demand would be affected by such achange, i.e. what would be the secondary effect of a fall in w.In a purely formal way the "Keynesian" model would show that nothing can happen, for w does not occur in the demandequations. This, of course could be quite easily remedied by using a differentiated savings function à la Kaldor.*(15) But fallingwages at no change in N1 means a fall in the wage share. Actually this would be likely to decrease demand even further. Againstthis one might say that profits are being increased and this could make investment more attractive, thus raising demand. In othercircumstances this could be a good argument. But even with variable proportions the unemployment of labour is most likely to beaccompanied by considerable excess capacity; this is hardly the kind of situation calling for an increase in the stock of capital. SoKeynes' scepticism regarding the efficiency of lowering money wages in restoring full employment (in the sense of raisingemployment) seems wellfounded.As a matter of fact it is surprising that so much attention is given to the flexibility of wages in the achievement of full employment,even after income demand came to be recognised as a central part of macro-analysis. As was mentioned before this would seem torest on the tacit acceptance of Say's law, which leads to the mistaken view that ND is more than a supply restriction. Only in adifferentiated savings model can flexible money wages play more than a subsidiary part.

5. The Fall in Price in the "Keynesian" ModelWith demand at Q1 the maximum profit condition is not reached and this can also be interpreted as the existence of excess supplyon the goods market or on each or the majority of markets for the various goods in the economy concerned. One would, therefore,

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expect the price level to fall. This can also be explained by referring to the behaviour of individual firms. These are not producing atfull capacity, i.e. at the maximum profit point, and from a micro-economic point of view they would be quite correct in thinking thatthey would raise their sales by lowering their price. This reasoning would be based on the shape of the demand curve and anindividual firm or even industry would succeed in raising sales by dropping price if it were the only one to take this sort of action.But in macro-economics one would encounter the well known fallacy of composition. When all firms drop their prices all industrydemand curves are liable to move left thus leaving the amount demanded on each market substantially unaffected. In fact when alllower their prices to raise sales they only succeed in lowering their revenue and thus the monetary value Y = pQ of the nationalincome. The point again is that in macro-economics one studies income demand and not price demand.

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It is interesting to note that even the old classical theory would not have based its case of rising demand on the price demandcurves but on the working of the quantity theory.As in the case of a fall in the money wage a decrease in the price level would not have any direct effect on the demand for goods oron the level of employment. So it is again the secondary effects or "round about repercussions" as Keynes himself calledthem*(16) that should be considered. However, before doing this we must again look at the "Keynesian" model in table 1, includingthe third difference between Keynes and the Classics which concerns Keynes' view on the money wage rate and the part it issupposed to play in making an underemployment equilibrium possible.Two factors are often mentioned in connection with the Keynesian view on wages. The one is that money wages are rigiddownward and the other that wage earners are subject to money illusion. Both would cause the supply curve of labour (at the realwage rate) to be perfectly elastic over a significant part of its length.The stickiness of money wages is as good or as bad an assumption as the inflexibility of the price level. It is true enough thatlabour unions will do all in their power to defend labour's share in the national output and their first line of defence is the moneywage. But usually wage agreements concern minimum not maximum rates. So even if with unemployment the minima will not easilychange, in time there will be a downward adjustment in earnings. In other words actual earnings will move closer to establis hedminima. Thus it could be argued that in the long term money wages can move down, even if they are rigid in the short term.Money illusion means that a change in the price level, therefore, in the purchasing power of money and thus the level of the realwage is not noticed. This assumption is usually sharply attacked on the grounds that trade unions do much of their bargaining onthe basis of the cost of living index. Actually this would strengthen the case for accepting money illusion provided it is supposedto be a short term or non-longterm phenomenon. After all the index only appears with a considerable delay and the change in theindex must be significant before unions can make out a case for higher wages.It would be satisfactory to assume that in the short term labour will, on the basis of money illusion, act as if the money wage is thereal wage. The amount of labour supplied would not react to a price change; a change in the money wage would, however, changethe amount supplied, as if the real wage had changed in the same way.As was mentioned before either or both of these assumptions are included in a formal presentation of the "Keynesian" system asin table 1 by using the following equation as the supply function for labour: (1.7)or more simply (4.7.1)If the money wage level is fixed in this way then there is only one thing that can happen when and if there is unemployment: thereal wage level must rise

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because, if prices change at all, they will drift downwards. If the real wage originally amounted to and if nothing else changes,especially demand, then the realwage rate rises to . It was already mentioned that this level of the real wagewould also be compatible with demand Q1 and employment N1.We now come to an often mentioned twist in the argument. Once the "Keynesian" equilibrium real wage has been reached it is saidthat a higher level of employment cannot be reached because the money wage is too high and therefore also the real wage. In otherwords there is a tendency for the wage level to be considered the cause of the unemployment equilibrium. But this must be false.The "Keynesian" real wage is not the cause but the effect of unemployment. This paradox is created by rigid wages, falling pricesand diminishing returns which means that at a lower level of employment firms experience a rise in marginal output. Again it is seenthat a drop in the money wage and therefore of the real wage from would not raise employment because demand would notnecessarily be affected directly, as the old classical school would have supposed.The rise in the real wage level as a consequence of unemployment can be criticised on two grounds. The first is partly empirical

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partly theoretical. Empirical evidence indicates that real wages do not move in a countercyclical fashion as the theory would haveit. But apart from this it would seem strange that a level of underemployment of less than 50 per cent of the full employment labourforce would actually make the majority of the labour force better off in a depression than in a boom. This would be even morestriking if unemployment amounted to "only" 10 per cent; for the 90 per cent in employment would experience an improvement intheir standard of living.The second point concerns the change in the price level when policy measures are taken to raise demand to the level Qf.Suppose that, demand having fallen as shown by the movement from IS1, to IS2, the fall in the price level has raised the real wageto . The diagnosis of this underemployment situation induces the authorities to consider the appropriate measures. These mayconsist of fiscal measures (moving IS2 back to IS1 or monetary measures, moving LM to LM', thus reestablishing demand at thelevel Qf.However, at the newly or recently established real wage N1K, Qf will not be produced, but only Q1 because of the maximum profitprinciple. There must, therefore, be a reflation of prices which is such that the real wage drops back to . The result would be that forfull employment to be reached the price level must of necessity rise. Now the term reflation is certainly not unknown but even so itshould in principle be possible in a situation of idle resources to raise output to near full employment level without raising the pricelevel. In fact it would appear that this is what Keynes and most others have in mind when discussing anti-unemployment policy.

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The question could, therefore, be asked why there should be this insistence on a rise in the real wage rate at least in a theoreticalanalysis of the problem. The answer must be found in the nature of the "Keynesian" model as given in table 1 and more particularlyin the inclusion in this model of the maximum profit condition (1.8)In the previous section it was shown that if the wage dropped to its classical demand level , then, although there would be nounemployment, the maximum profit condition would be far from fulfilled. However, if the money wage level is fixed as per (1.7) andthe price level variable then the real wage would rise to . The marginal output curve ND shows that at this real wage the maximumprofit condition would be precisely fulfilled. In other words the "Keynesian" model is determinate and it can show an equilibrium atless than full employment.In the previous example it was shown that the real wage could not fall below ; in the present case the real wage cannot rise above .Suppose that with the money wage fixed the price level falls to such an extent that the real wage rises to N0S. Although demand isat Q1, so that the output of N1 units of labour could be sold it would not be profitable to employ N1; for at N1 : . Output is,therefore, restricted to Q0.But since Say's Law is not supposed to apply demand remains at Q1. Whereas in the previous case there would be an excessdemand for labour there is now an excess demand for goods. This will raise price until the real wage returns to . Demand is beingsatis fied and no further price change will now take place.The solution is no doubt elegant and so convincing that the validity of the "Keynesian" model is seldom questioned. Yet it will beshown in the next section that it is quite likely that actual Keynesian underemployment theory has been made subject to therequirements of a system of simultaneous equations rather than the other way around.In a previous contribution to this journal a model similar to the "Keynesian" one in table 1 was discussed.*(17) The question posedthen (although in a somewhat different context from the present one) was whether in such a model it would be possible to work inreal terms only, i.e. to ignore the price level as a variable. If one leaves out p as a variable or adds the equation (4.8)to the system the model would be overdetermined. To remove the overdeterminacy

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of the model one would have to do one of two things: either drop an equation or add a variable. But which equation or whichvariable?The argument in the previous article ran as follows:First of all, one cannot very well do without the Hicks-Hansen equations as contained in (1.1) to (1.4). Since one studies incomeand employment one would certainly need an indication at what wage rates (whether real or money) supplies of labour would beforthcoming. So one cannot either drop whatever version of (1.7) one has decided to use. Nor can one do without a technicalrelation (1.6) showing how much labour is required to satisfy real demand, (Q) as given by the IS - LM functions. The profitmaximisation condition could not be ignored because this, after all, is one of the basic laws of economics. The result was that anadditional variable was selected; the choice fell on the amount of capital (K). This fitted quite nicely into an analysis of someaspects of macro distribution theory and also showed up some aspects of long term analysis, even if the precise definition of thelong term may leave something to be desired.

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The retention of the maximum profit equation was not questioned. For even in Keynesian underemployment economics it wasconsidered impossible to depart so far from generally accepted theory. Moreover, what would be the logic in such a procedure, i.e.dropping the price level as a variable and then in a seemingly arbitrary way dropping profit maximisation to make the model work. Inother words it seemed very difficult to back up such a change in the mathematics of the model by an economically meaningfulchange in the underlying theory.

6. The Secondary Effects of a Fall in the Price LevelIn section 4 above it was explained that a fall in the wage rate, whether money or real, would not necessarily have any noticeablesecondary effect on demand, and that even in the case of a differentiated savings model this effect would probably be perverse inthe case of underemployment. The price level is a different proposition altogether. For the sake of simplicity the secondary effectsof a price change were left out of account in section 5. This must first be rectified.The demand deficiency at Q1 it was said, would lead to a fall in p and this would raise the real wage. The real wage level would inother words start crawling up along ND from F towards K. Now the IS - LM diagram is given in real terms but this does not meanthat the curves are independent of the price level. This can be seen at once when (1.4) and (1.5) are combined to read:M = kpQ + fm (r)which is the equation describing LM curves.A drop in the price level would diminish the active funds needed to support each level of Q and hence LM would move to the rightthus raising the amount demanded via a fall in the rate of interest. With demand moving from Q1 towards Qf employment would ris efrom N1 in the direction of Nf. Naturally this would move marginal output along ND from K to F. Eventually a stage is reached18. Ibid. p. 364.

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when MO and meet at a point such as T. Demand is now exactly met so that the fall in price will stop. Again it is clear that but thisoccurs at a level of employment below full employment.The rigidity of the money wage prevents the achievement of full employment and this could well be regarded as the main feature ofthe "Keynesian" system in table 1.*(18)One could, of course, put the blame for the situation also on the rigidity of the monetary system for an increase in M would raisedemand. With price at the level determining LM' there would be excess demand for goods, which would raise prices and providedM is raised enough demand will stay at Qf and the real wage is lowered to .Nevertheless, this would require policy measures which fall outside the model as it stands. The rigid money wage, therefore,remains a problem. This is why it is necessary to look again at the proposition that, at least in the case of downward adjustments,price should be considered as a long term variable.There are two possible reasons that may be adduced to show that this would be a reasonable supposition. The first is thatemployers are not unlikely to be reluctant to lower their prices. Apart from this a fall in p is a fall in the general price level, that is ofall, or a majority of prices, as a consequence of underemployment. It may well take some time before such a situation is diagnosedcorrectly. This probably must be contrasted with a situation of excess demand on the goods market which is likely to lead toquicker reactions.Secondly the fall in price has its effect via the demand for active balances and the money market. The Keynes effect as describedabove is an indirect effect, it is part of Keynes' "roundabout repercussions". This also indicates that some time may pass before theeffect on demand is noticeable.But if this were accepted then the supply curve of labour must be reconsidered. It was mentioned earlier on that money illusion aswell as downward rigidity would not be appropriate assumptions in a long term or longer term analysis. If price is a long termvariable and treated as such then a model containing p cannot at the same time contain . But if one replaces (1.7) by (2.7) one hasthe neo-classical model described in table 2 and the only possible equilibrium would be full employment so that one loses thepossiblility of underemployment equilibrium required by a Keynesian model.The matter may be viewed from a slightly different point of view and this is that a model containing price as an operative variableshows a strong tendency towards a full employment equilibrium. This is so, first, because of the Keynes effect and secondlybecause of the Pigou effect. Thus it was found just now that

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with demand originally at the level Q1 the Keynes effect would tend to raise demand to Q' and employment to N'. This wouldalready be a move back towards full employment. The fall in price may, however, also move IS to the right. This would lead to priceincreases which would lower the real wage further and remove the existing supply restriction at T, so that at least part of thisdemand can be met. It would, therefore not be impossible to achieve full employment even with a rigid money wage. The trouble is

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that price rises would move both IS and LM back, perhaps even to intersect at A1 again.Now if it is first and foremost the variation in the price level that would set in train forces leading the system back towards a fullemployment equilibrium then it is the price level that should not occur in a Keynesian model. This opinion is reinforced if accountis taken of the fact that a Keynesian model is generally acknowledged to be a short term model and if price is considered as a longterm variable. But taking out price as a variable (or adding as an equation) would overdetermine the system. This means there isone equation too many; the one to be removed is the maximum profit equation.That this provides useful results was already explained with reference to the maximum profit principle. Taking out the maximumprofit equation can also be seen in the light of removing the definition of the full employment real wage level from the model assuch. The maximum profit condition does, however, place a restraint on the amount of output and this must now be included in theproduction function as follows:Q = f(N); (4.6)As stated by the maximum profit principle this would mean that (at a given price level) employers would produce any amount ofoutput demanded up to and including the point at which marginal output equals the real wage and, therefore, up to the level of fullemployment.

7. Comparing the Keynesian with the Neo - Classical SystemIt is no wonder that in the thirty-five year old debate between Keynes and the classics the combatants should long since havestarted to show signs of mental fatigue if not boredom. According to one author the two sides have agreed to differ on the basis ofthe proposition that the neo-classical system is theoretically more convincing but that the Keynes approach is more useful toissues of practical policy.*(19) What are the main conclusions that may be drawn from the arguments in the present essay? Thesearguments may be reviewed by comparing the models contained in table 1 with those given in table 2.In the first place it was found that in the traditional way of contrasting the Keynesian with the classical system the classical modelrepresents palaeo-classical rather than neo-classical theory. Thus it would not be the traditional three differences (as contained inthe first, fourth and seventh pairs of equations in table 1)

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that distinguished the classical from the "Keynesian" model but rather the theme that was central to the theory. The old classicalschool argued with the labour market as its point of departure, whereas in the "Keynesian" model demand, more specifically incomedemand, would take pride of place.The old classical school could do this and use the analytical instrument of price demand, borrowed from micro-economics, in theirincome theory because of their acceptance of Say's law. If Say's law applies then the marginal output curve (2.8) would indeed be ademand curve for labour; but if not, not. Yet even today this curve is usually described as the demand for labour, showing thatSay's law is far from forgotten.TABLE 2

3. Neo-classical 4. Keynesian

3.1 S = fS(Q,r) 4.1 S = fS(Q,r)

3.2 I = fi(Q, r) 4.2 I = fi(Q, r)

3.3 I = S 4.3 I = S

3.4 M = kY + fm(R) 4.4 M = kY + fm(R)

3.5 Y = pQ 4.5 Y = pQ

3.6 Q = f(N) 4.6 Q = f(N)

3.7 N = f 4.7 4.7.1 or

4.7.2 N = f

3.8 4.8 ()

Two points are correctly made in the by now traditional "three difference comparison" of Keynes and the classics as in table 1. Thefirst is that both the old and the new classical theories consider full employment the only possible long term equilibrium. Thesecond is that in a Keynesian system one takes income demand as one's central thesis and not price demand (in real terms) on thelabour market. What is wrong is to suppose that it is only in Keynesian economics that the argument is set out in this way. Also in

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neo-classical macro-economics one would argue from the point of view of income demand exemplified in the first three equations ofthe "Keynesian" model. This is shown in table 2 by using the identical demand equations in both the neo-classical and the trueKeynesian model (now without quotation marks).As a matter of fact the neo-classical model in table 2 differs from the "Keynesian" model in table 1 only with regard to the laboursupply function; for in the neo-classical model it is assumed that the money wage is not rigid and/or there is no money illusion.This would ensure the eventual achievement of full employment. The existence of the liquidity trap (as in (3.4)) or inconsistencybetween saving and investment would not be serious. For that matter an inconsistency between labour supply and the marginalproductivity of labour which would definitely prevent full employment is usually not mentioned. This is the case of the developingeconomy with structural unemployment, which is a relevant point today.

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In the neo-classical model the important point would be that changes in the price level affect income demand as determined by theHicks-Hansen equations in a roundabout way. Whether price changes occur would depend on the existence of unemployment orovercapacity as defined by the last three equations in the model.The difference between the neo-classical and the Keynesian model in table 2 is contained in the last three equations. If it isaccepted that excess supply on the goods market, which is caused by a general demand deficiency rather than by an imbalance onone particular market, will cause a delayed reaction in the price level; and if furthermore this reaction works in a roundabout way viathe Keynes and Pigou effects this would mean that a Keynesian model, which is short term, should not contain p as an operativevariable. This would be implied by (4.8). Since unemployment is caused by a demand deficiency, producers would do as well asthey could by attempting to come as near as possible to the actual maximum profit condition. Instead of a separate equation as in(3.8) it would now be a restriction on the production function, as in (4.6).The supply of labour as in (4.7) is quite interesting. The "Keynesian" model in table 1 could be called inconsistent in the sense thatit contained p, which is considered to be a long term variable whereas (1.7) was based on short term considerations of wage rigidityand money illusion. Removing price as a variable means that a short term version of labour supply can now again be adopted. Onemay, in fact, take one's choice which of the versions to use. It would even be reasonable to use (4.7.2). Since the price level is giventhis would automatically mean that the supply of labour is a function of the money wage; this statement is quite in agreement withKeynesian theory. It would even be useful to writeN = f (w) (4.7.3)which would imply that one allows for changes in earnings in a depression.If the Keynesian system is described as in table 2 it would appear that the main difference between Keynes and the classics,neo-classics that is, must be found in the treatment of the general price level. It was mentioned a number of times that theKeynesian system would not contain p as an operative variable. This would mean that the adoption of (4.8) in the model does nothave to imply that the price level is rigid. However, it does have to mean that there is not sufficient time for a change in P to affectincome demand; for as soon as this is allowed for one returns to neo-classical theory. A downward drift in prices could quite wellbe accompanied by a downward drift of earnings which would leave the real wage level unaffected.The usefulness of this interpretation of the Keynes-classics controversy is that it shows that the two theories are not substitutesfor each other; rather they complement each other in the same way as Marshall's price theory for periods of different length.The interesting point about this is that Blaug's remark quoted in section (1) above can be shown to be both right and wrong. Asshown in table 2 Keynesian and neo-classical economics can be contrasted in a formal way. Yet it is clear that the two systems arebasically different in the sense that the one is long term and the other short term. In fact Blaug himself mentions that on an earlierpage:

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"neo-classical macroeconomics is almost solely concerned with the properties of equilibrium states; Keynesian macroeconomics isalmost solely concernedwith disequilibrium states".*(20)The addition of the term "longterm" would make this remark coincide almost completely with the point of view defended here, forshort term equilibrium states are usually long term disequilibrium states. Looking at the two (sets of) theories in this way obviatesthe necessity of declaring the one superior to the other. They both have their place in income theory, just as short and long termprice analysis have their place in Marshallian price theory.The present essay was also an attempt to identify the reason why Keynes's should be called a short term theory as against thelong term theory of the neo-classical economists. The policy implications of Keynesian theory are left unaffected for even whenmodel (3) is accepted for the long term, it may be socially and politically impossible to wait so long; and this, after all, is whatKeynes was concerned about.

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The Keynesian model as presented here removes the necessity of supposing that the real wage rises when there is unemployment.This also means that when income demand is stimulated by monetary and/or fiscal policy to return to the full employment real levelQf, there is no necessary increase in the price level which is indeterminate in the short term. And lastly the Keynesian model showsKeynesian economics as it was designed to be: the economics of underemployment.What could well be raised as an important criticism of the two models presented in table 2 is that they do not really cater for thetype of economic problem that is very relevant today: inflation. If inflation is defined as the consequence of excess demand on thegoods market then model 4 would not work since maximum output is limited by the restriction in (4.6). But, more importantly: pricedoes not occur as a variable so that there is no mechanism to achieve any sort of equilibrium.Now in the long term model (3) this does not apply and an equilibrium is quite definitely identified. However, would it be correct tosuppose that in inflationary times the general price level can be treated only as a variable for some type of long term? Somehow thiswould go against the grain. In the concluding section which now follows an inflationary short term equilibrium will be discussed.

8. The Possibility of a Keynesian Over - Employment EquilibriumAs was mentioned in the previous section inflation will occur when on the goods market the amount demanded is greater than theamount supplied. Such a situation is described in fig. 2 by A1 the intersection of IS and LM2 (at some earlier stage a fullemployment and non-inflationary equilibrium may have existed as determined at A0 ). Intersection A1 indicates that demand will beQ1; this would require, according to the production function, N1 units of labour; but if NS is the labour supply function and if NDis the marginal output function this would mean that the maximum profit principle cannot be complied with; for marginal output

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FIG. 2.would be lower at N1 than the real wage rate payable at this level of employment. As was mentioned before, producers do not haveto produce at a rate equal to the amount demanded. Since the level of employment Nf would be the highest at which does not fallbelow , they would not produce more than Qf. Since Q1 > Qf, so that there would be excess demand, the price level will go up.An attempt was made in the previous sections to show that in a situation of underemployment, i.e. excess supply on the goodsmarket, price could best be treated as a long term variable. In the present case, the other side of the coin as it were, it would beequally reasonable to consider price a short term variable on

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the supposition that buyers will most likely be less hesitant to offer higher prices in case of excess demand than sellers would be tolower their prices in a case of excess supply. Perhaps on the same score it would be reasonable to assume that demand would beaffected fairly speedily e.g. by a reverse Keynes effect which would move LM2 towards LM'. In the same way IS could besupposed to move backwards on the basis of a reverse Pigou effect (not shown in the diagram). Provided the inflationary processitself does not affect liquidity preference and consumer spending, and provided the quantity of money is kept from rising, thisprocess could by itself be assumed to stop the inflationary process.Now expressed in the formal terms of a model of simultaneous equations the above set of reactions would be contained in theneo-classical model as in table 2. This would mean that one need not go to any trouble describing price as a short term rather than along term variable as was done so far. However it can be shown that, just as there is a possible short term underemploymentequilibrium, there may be a short term overemployment equilibrium; that is to say an equilibrium at a level of employment beyondthe full employment mark. This can be called a Keynesian equilibrium because the model on which it would be based is, in fact, the"Keynesian" or pseudo-Keynesian model in table 1.In the present essay the difference between the "Keynesian" model and the neo-classical one lay in the supply function of labour.The Keynesian labour supply function would be based on the assumption of the rigidity of money wages in a downward direction,as well as money illusion. The Allen equation (1.7) in table 1 would show clearly that money wages could move upward. However,since Keynesian economics concentrates on underemployment, an upward movement of the money wage receives little attention inthe literature, since it is hardly relevant in the circumstances.This is, however, not so as far as the problem in hand is concerned. Just as there is an excess demand for goods it can be supposedthat there is an excess demand for labour; or alternatively producers, experiencing rising prices, can afford to pay higher moneywages. The question is what will happen to the real wage. Obviously there are three possibilities.The first possible reaction is that the money wage rises faster than the price level, so that the real wage rises. The real wage couldfor instance, rise to .Now on the evidence described earlier on, this would have to mean that employment cannot exceed N3, and this would cut backoutput below the full employment level at Qf. Even if the increase in price has through "roundabout repercussions" already cut

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back demand from Q1 to Q2 (cf. LM' and A2 ) the rate of inflation (accompanied by unemployment) would be likely to increase. Thiswould be on the not unreasonable assumption that the rate of inflation is a positive function of the size of excess demand.However, in the initial stages of inflation this is not, it would seem, an important possibility.

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The second case would be the one where p and w rise at the same rate. The real wage rate would not change. Employment wouldstay at Nf and output at Qf. If demand was now at Q2 one could suppose that the rate of inflation has slowed downThe third case is the most interesting and, in the short term and in the initial stages of the inflationary process, perhaps the mostlikely: the money wage rate rises, but at a slower rate than prices so that the real wage level drops. Suppose, for instance, that inthis way the real wage drops from to .Provided the rise in the price level has not in the meantime lowered demand below Q2, this would mean that employers would wishto employ N2 units of labour. However, according to the labour supply curve only N4 units are available at this level of the realwage. As in the first case this would have to mean that output drops below Qf thus again reinforcing the inflationary process. Themoney wage would now be likely to start rising at a faster rate than the price level, for excess demand for labour can now definitelybe diagnosed (amounting to N2 N4). Thus employment would return to Nf and one could hope that it would arrive there at thesame time that demand drops to Qf.This analysis would be correct if it had been announced as a long term analysis to begin with. But this was not the assumption; asa matter of fact it was stated that a Keynesian labour supply function would be used to keep to a short term model.The supply function to be used would be a money illusion function. The amount of labour supplied on the market would, in otherwords, be a function of the money wage and this could best be expressed as follows: N = f (w) (4.7.3)Now one should again be clear as to the sort of arguments on which such a function is based. Money illusion means that it takestime for people to notice a general rise in the price level. They will, therefore, in the short term behave as if the money wage werethe real wage. This is not as strange as it may seem. After all, if the price level is constant, then a change in the money wage alonedetermines the change in the real wage (cf. equation (4.7.2)). If a change in the price level is not noticed (in the short term) thismeans it cannot be taken into account; in fact it seems as if it had not taken place at all. Hence the use of (4.7.3) in a short termmodel.In the case being discussed now the real wage was supposed to have dropped from to . This fall in the real wage had come aboutby a stronger rise in p than in w. Suppose that the original price level was pf and the original money wage wf so that: = Further suppose that = , where w1 > wf and p1, > pf,but so that the real wage falls.

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Now the point is that according to (4.7.3) the change in price from pf to p1 plays no part in labour supply but the change from wfto w1 does. As was mentioned just now, suppliers of labour have not had time to notice the rise in prices; as far as they areconcerned the price level pr still applies and they therefore mustthink that the real wage has gone up from to = But if this is what they think, they will act accordingly and they will, therefore, raise the number of labour units supplied on themarket from Nf to N'.It was shown above that at the real wage level = producers would employ N2 workers provided demand was not deficient.Suppose that the rise from pf to p1 has, in fact, cut back demand to Q2, then the number of work units demanded would be N2exactly. According to the previous paragraph the number of labour units offered in the short term is N', which is even more than N2.Q2 can therefore be produced and since supply meets demand the inflationary process is stopped 3/4 for the time being.Now this short term or Keynes type equilibrium does depend on money illusion on the part of workers and no money illusion onthe part of employers. Yet this is a reasonable supposition. Every employer compares the wage he has to pay with the price of hisone product and attempts to equalise marginal revenue product to the money wage: p = w. As far as workers are concerned, this isnot so.They have to compare w with the prices of an infinite number of goods they wish to purchase. Clearly this is far more complicated.It could be objected that this proposition would not hold in a one product economy. In fact in a one product economy there couldbe no money illusion.The overemployment equilibrium is possible because workers mistook a rise in the money wage for a rise in the real wage becauseof money illusion. This equilibrium can, therefore, not last longer than money illusion and since money illusion is confined to theshort term the equilibrium is itself confined to the duration of this period.

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In the long term workers will withdraw from the labour market (cf. N4), and thus restart the inflationary process which wastemporarily stopped. This could also be interpreted as trade unions agitating for and obtaining higher wages. In either case it canbe said that the impetus for this new round of inflation comes from the side of labour. This seems to be one way in which cost pushinflation can be explained. The impression of cost push is strengthened by the fact that wages must now rise faster than prices forelse no upward adjustment in the real wage is possible. At the same time there would be a tendency for the level of employment torecede (from N2 towards Nf).Ever since the thirties governments have been concerned about the maintenance of full employment to which, since the war hasbeen added the maintenance of price stability. Recent experience has shown that the latter is extremely difficult to achieve. As animportant reason for this is mentioned the fact that it is far more

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difficult to restrict demand by fiscal and monetary demand management policies than it is to raise demand by these means.Particularly worrying is the fact that even with a very strong demand restricting policy inflation may not be stopped because offurther rises in the wage level. The consequence is that many experts advise the authorities to try and restrain labour from makingexcessive wage demands for instance by setting guide lines limiting wage rises to rises in labour productivity. This is calledincomes policy.It is true that the Keynesian overemployment equilibrium as described here is a highly stylised and simplified version of what takesplace in real life. Yet it would appear that there is one difficulty that is illustrated rather well in fig. 2: the difficulty of in practicedistinguishing between a short term and a long term equilibrium.In this essay a great deal has been said about short term and long term analysis. Now a long term equilibrium is known as asituation towards which an economy will move provided nothing happens to disturb this process. On this score a short termequilibrium is far more likely actually to come about and such an equilibrium, or something close to it, may therefore on occasion benoticed in real economic life.It is, therefore, not altogether impossible that the overemployment equilibrium as described may actually occur and be diagnosed.So: employment is at N2 and prices are relatively stable; both facts can be measured statistically. It is not unlikely that N2 would,therefore, be designated as a bench mark for full employment, for it is extremely difficult, if not impossible, to distinguish N2 fromNf. This would mean that unemployment is likely to be diagnosed as soon as employment falls below N2.If the diagram in fig. 2 is a reasonable representation of what could actually happen then it can be shown that incomes policy mustnecessarily fail even with a completely successful monetary and fiscal policy.The attractive idea behind incomes policy is, that if labour can be restrained from putting in demands for significantly rising realwages then no inflation would occur. Suppose, therefore, that the real wage is kept at the level . If NS is the supply curve then lesslabour will in the long term be offered for hire at this real wage, output will drop and inflation will start again. This will also happen ifdemand is cut back to Q2. Only if demand dropped all the way to Q4 (associated with N4) could the inflationary process be halted.This would seem to be the induced type of unemployment prevalent in some countries today.The only cure would, therefore, be to allow real wages to rise and to lower one's sights as far as the level of full employment isconcerned. However, this course may also be dangerous. Just as inflation may and does develop a momentum of its own, this canhappen to the process of making wage demands. There is no guarantee that real wages will in this case not rise above and thiscould well meanthat employment cannot exceed N4 again (limited this time by the marginal output level). Demand night well stay at Qf and thusinflation would go on, in spite

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of unemployment. In fact a drop in employment which means a drop in output is far from an unmixed blessing (except perhaps tothe balance of payments) to price stability. In this case incomes policy could, of course, be useful. There is one possible solution tothe problem posed by overemployment. This is to effect a rightward shift in the ND curve (cf. N1D). The marginal outputrestriction would move upward thus moving Nf to the right. This would basically be a long term process based on investment but itcould stay ahead of the disappearance of money illusion. This also shows that a policy of demand management, which could affectinvestment, may be inflationary over the long term.University of South Africa,Pretoria.

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Endnotes1 This type of comparison may be found, i.a., in: G. Ackley: Macroeconomic theory, The MacMillan Company, New York, (StudentEdition) 1966, p. 403; R.G.D. Allen: Macro-economic theory, a mathematical treatment, MacMillan, St. Martin's Press, New York,1968, pp. 131 et seq.; M. Blaug: Economic theory in retrospect, (2nd edition) Heinemann, London. 1968, chapter XV (pp. 635-665). K.C. Kogiku: An introduction to macroeconomic models, McGraw Hill, New York 1968, ch. 5 (pp. 109-132) and in: M. K. Evans:Macroeconomic activity, theory, forecasting and control: an econometric approach, Harper & Row, New York, International edition,1969, p. 347.

2 Cf. Th. F. Dernburg & D. M. McDougall: Macroeconomics, the measurement, analysis and control of aggregate economic activity,McGraw-Hill, New York etc., 1968, p. 194 and p. 204; D. C. Rowan: Output, infflation and growth, an introduction tomacroeconomics, MacMillan, London etc. 1968, pp. 352 et seq ; C. G. F. Simkin, Economics at large, an advanced textbook onmacro-economics, Weidenfeld & Nicolson, London 1968, pp. 126 et seq.; also Blaug (op. cit.) p. 635; Allen (op. cit.) p. 132; Kogiku(op. cit.) p. 112.

3 The Keynesian labour supply function is often written as ; cf. Evans, (op. cit.) p. 347; Ackley (op. cit.) p. 403. Equation (1.7) in table1 is used by Allen (op. cit.) p. 125.

4 Cf. Allen's remark: "Which of these differences is the crucial one? Opinions differ so much on this question that the naturalconclusion is that they all contribute in their various ways to the distinctive features of the Keynesian model" (op. cit. p. 132) andAckley (op. cit. p. 404): "Which of these constitutes the really crucial difference between Classical and Keynesian analysis? Someeconomists have said that it is the first of these differences, others that it is the second others the third, while still others say it isnone of these but something else that does not show up directly in this formal structure". The argument in this essay is that thedifference does show up in the formal structure but not via the three differences mentioned.

5Blaug (op. cit.) p. 652.

6Cf. Allen (op. cit.) p. 104 and p. 132; Kogiku (op. cit.) p. 123.

7The labour supply curve NS in figures 1 and 2 is based on the assumption that there is a socially acceptable level for the minimumreal wage below which the real wage cannot fall. At this level the labour supply curve would become perfectly elastic. Thisassumption is also used by W. A. Lewis. If ND intersects NS in this part there would be structural unemployment which is relevantto developing economies. NS shows further that between NO and NMAX more labour can only be obtained at ris ing real wages. AtNMAX all of the labour force is employed and NS becomes perfectly inelastic. The shape of NS does not significantly affect theanalysis in this essay. NMAX is maximum employment but not full employment which is defined by intersection F.

8 The implication of the real wage and the curves ND and NS would seem to be that this situation is brought about by a fall in labourdemand from a level where it intersected NS at L. Such a fall in labour demand is possible in micro-economics when ND would be amarginal revenue product curve. A drop in the price of the product would shift w the MRP curve, which can happen because theprice of that product does not materially affect . But this is impossible now and ND can only move with a change in the productionfunction which is a (very) long term phenomenon.

9 This consideration is sometimes mentioned. Cf.: J. Lindauer: Macroeconomics, John Wiley & Sons, Ltd., New York etc. 1968, p. 203.

10This is nothing new, cf. the following remark from Dernburg & McDougall (op. cit. p. 204): "In the classical model the sequenceruns from the level of employment to the level of income, consumption, and investment ... In the Keynesian system it is helpful tothink of the sequence as running in the other direction." In this essay it is argued that the latter remark applies to both Keynesianand neo-classical theory; the former would apply only to the old classical theory.

11+To make the visual exposition a little easier it has been assumed that the scale of N and Q are such that Q and the appropriate value

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of N can be shown on the same line perpendicular to the horizontal axes. Actually of course N can be found from Q graphicallyonly via the production function in panel (2) on the right. This remark applies both to fig. 1 and to fig. 2.

12This agrees for instance with Lindauer's remark that " . labour demand curves of the type described merely represent the maximumnumber of workers that will be demanded in an economy at each level of real wages" op. cit, p. 203 (italics added). That the NDcurve is not the usual sort of demand curve of labour is also stated by E. J. Mishan: "The demand for labour in a classical andKeynesian framework".Journal of Political Economy Vol. LXXII (1964) reprinted in J. Lindauer: Macroeconomic readings, Collier-Macmillan London, 1968,pp. 137-142. Mishan attacks the basic hypothesis of perfect competition and diminishing returns. This does not seem necessary.

13 This type of equilibrium is similar to Barro and Grossman's interpretation of Patinkin cf.: R. F. Barro & H. I, Grossman "A generaldisequilibrium model of income and employment" American Economic Review, Vol. LXI, no. 1. March 1971, pp. 82-93.

14 Yet it is the old classical school that used the subsistence minimum. The subscript C refers to classical theory. K and refer to aKeynesian equilibrium level of real wages.

15 i.e. by writing S = swW + spP; sw < sp. One would add also: W = wN and Y = W + P. W is the wagebill is non-wage income; thepropensity to save out of wages and the propensity to save out of non-wage income ("profits"). Cf. F. van den Bogaerde:"Makro-ekonomie en die verdelingsleer , SAJE v38(4) p344-366.

16 J. M. Keynes: The general theory of employment interest and money, MacMillan, London, 1942, p. 257.

17 F. v.d. Bogaerde, op. cit. pp. 352-4.

18 This Neo-Keynesian argument can i.a. be found in: W. L. Smith: "A graphical exposition of the complete Keynesian system:The Southern Economic Journal, Oct. 1956, pp. 115-125; reprinted in: M. G. Mueller (ed.): Readings in macro-economics, HoltRinehart and Winston, London etc. 1970, pp. 37-45.

19 Cf. Axel Leijonhufvud: On Keynesian economics and the economics of Keynes, Oxford University Press, London, 1968, p. 7.

20Blaug, op. cit. p. 651.

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