Wage Behaviour and Unemployment in

Keynes’s and New Keynesians’ Views.

A Comparison

Nicola Meccheri∗

Revised version: December 6, 2005†

∗
Dipartimento di Scienze Economiche, Facoltà di Economia, Università di Pisa. Via
C. Ridolfi 10, I-56124 Pisa, Italy. Tel.: ++39 050 2216377,fax: ++39 050 598040, e-mail:
meccheri@ec.unipi.it

†
Special thanks are due to Carlo Casarosa, Geoffrey Harcourt, Neri Salvadori, Maurizio
Zenezini and two anonymous referees for their thoughtful and extensive comments and
suggestions. I would like to thank also Davide Fiaschi, Francesco Filippi, Mario Morroni
and Carlo Panico for their comments on a previous draft. Of course, all errors remain my
own.

1
 Abstract

The paper compares different strands of New Keynesian Economics

with respect to Keynes’s original work. In particular, two issues are
analysed in detail. First, the explanations provided by Keynes and
New Keynesians of nominal and real wage behaviour. Second, the
different theories and interpretations concerning the ability of flexi-
ble nominal wages in assuring full employment. It is argued that,
although persistent involuntary unemployment is a central problem
both in Keynes’s and New Keynesians’ views, referring to the role of
nominal and real wages in explaining unemployment, New Keynesians
theories present important features which differ, sometimes substan-
tially, from the concepts developed by Keynes in his General Theory.
In this direction, hopefully, further clarifications of the issues involved
are presented.
Keywords: Keynes, New Keynesian Economics, Nominal Wages,
Real Wages, Unemployment
JEL codes: B20, B40, E12, E24

2
1 Introduction
Introducing the New Keynesian Economics (NKE) symposium in the Journal
of Economic Perspectives in 1993, Gregory Mankiw, a leading New Keyne-
sian economist, stated that “like Keynes, new Keynesians begin with the
premise that persistent unemployment and economic fluctuations are central
and continuing problems” and that “traditional expositions of Keynesian
economics emphasized the role of rigidities in nominal wages and prices”
(Mankiw 1993, pp.3-4). New Keynesians also argued that in traditional
Keynesian economics “crucial nominal rigidities were assumed rather than
explained” (Ball, Mankiw and Romer 1988, p.2). Thus one of the most
important contributions of NKE to Keynes’s original work has often been
associated with the improvements obtained in providing acceptable micro-
foundations for the phenomena of wages and prices sluggish adjustments.1
Nevertheless, this interpretation may be strongly misleading if it conveys the
impression that Keynes considered rigidities as being somehow responsible
for his most important results.2
This paper aims at comparing different strands of NKE with respect to
Keynes’s original work on wages, pointing out the real contributions of the
NKE and describing the major differences and analogies between ‘the master
and his descendants’. In particular, two issues will be analysed in detail.
1
This result is clearly stated also by two other prominent New Keynesian economists
when they argue that “The New Keynesian Economics [...] succeeds both in filling the
lacunae in traditional Keynesian theory (e.g. by explaining partial wage rigidities, rather
than simply assuming rigid wages) and resolving the paradoxes and inconsistencies of more
traditional Keynesian theory ...” (Greenwald and Stiglitz 1987, p.126). While Greenwald
and Stiglitz (1987) provide a broad comparison between the NKE and traditional Keyne-
sian economics focusing mainly on capital markets, in this paper attention is concentrated
on the labour market.
2
For a broad discussion in the same symposium on the JEP, see Tobin (1993). In
particular, Tobin stressed that “the central Keynesian proposition is not nominal price
rigidity but the principle of effective demand” (Tobin 1993, p.46).

3
First, the explanations provided by Keynes and New Keynesians of nominal
and real wage dynamics. Second, the different theories and interpretations
concerning the role of flexible nominal wages in assuring full employment in
the economy. In these perspectives, the paper, hopefully, presents further
clarification of the issues involved.
One of the most widely discussed issues about Keynes’s contribution lies
in his explanation for a possible source of downward nominal wage stickiness.
This explanation has become the target of numerous unfair attacks and it
has been criticised as being based on irrational behaviour by workers. Such
criticism is groundless since the explanation provided by Keynes is theoreti-
cally valid besides being confirmed by empirical observations. Nevertheless,
some other points in Keynes’s analysis concerning wage dynamics should be
more deeply explored and in this direction NKE has been effectively able to
provide its own contribution.
Concerning the capacity of nominal wage reductions in restoring full em-
ployment, it is well known that Keynes did not believe that nominal wage
rigidity was the main source of unemployment and, as a consequence, that
nominal wage cuts were not the proper cure for it, and might not be a cure at
all. In this perspective, the strand of NKE which focuses on nominal wages
and price rigidities seems to be in contrast with Keynes’s view since, in such
a New Keynesian framework, flexible wages and prices would allow the econ-
omy to maintain full employment. On the other hand, as will be discussed
below, other New Keynesian theories, albeit with some major distinguishing
features, seem to reinforce Keynes’s conclusion.
It is important to clarify here the ‘boundaries’ of this paper. Theories
labelled as ‘Keynesian’ are extremely various and different as well as the in-
terpretations given to Keynes’s original work by his successors (e.g. Patinkin
1990). As already indicated, the paper aims at comparing in detail Keynes’s
ideas, as propounded mainly in The General Theory, with the New Key-
nesian models that have been developed since the end of 1970s in order to

4
provide more solid micro-foundations for the phenomena of wage and price
rigidity. By contrast, other important theories which commonly belong to the
Keynesian tradition, such as the famous ‘Neoclassical Synthesis’ (e.g. Hicks
1937; Modigliani 1944), the fixed prices or general disequilibrium models
(e.g. Clower 1965; Malinvaud 1977), and the Post-Keynesian school (e.g.
Robinson 1973; Chick 1983), are not considered, except only incidentally, in
this paper. This choice of focus in the paper also explains why the analysis
that follows concentrates on the short run (given technology) and on a closed
economy. This is because, to the best of my knowledge, ‘the Keynes versus
NKE debate’ on wage rigidity and unemployment has advanced over the last
two decades mainly in such a framework.
The rest of the paper is structured as follows. Section 2 describes Keynes’s
analysis of nominal and real wages behaviour and presents some New Key-
nesian contributions, emphasising major differences and similarities with
Keynes’s original work. Given its particular relevance, the issue of differ-
ences about Keynes’s and alternative New Keynesians’ views concerning the
ability of nominal wage flexibility in restoring full employment is separately
analysed and deferred until Section 3. Finally, these observations are drawn
together in the concluding Section 4.

2 Nominal and Real Wage Dynamics

2.1 The General Theory of John Maynard Keynes

At the beginning of The General Theory (GT, Ch.2) Keynes assumed that
the nominal wage was constant in order to facilitate the exposition of his
argument but he clarified that “the essential character of the argument is
precisely the same whether or not money-wages [...] are liable to change”
(GT, p.27). Keynes presumed that nominal wages were as a rule a function
of activity, tending to rise and fall with the level of output and employment.

5
Concerning the relationship between nominal and real wages, Keynes argued
that:

It would be interesting to see the results of a statistical enquiry into

the actual relationship between changes in money wages and changes
in real wages. [...] But in the case of changes in the general level
of wages, it will be found, I think, that the change in real wages,
is almost always in the opposite direction. When money-wages are
rising, that is to say, it will be found that real wages are falling; and
when money-wages are falling, real wages are rising. (GT, p.10).

In a subsequent article (Keynes 1939) related to the debate on relative

movements of real wages and output (which shall be discussed below), Keynes
pointed out that in order to correctly understand the passage of The General
Theory quoted above, it is important to distinguish between two different
situations.
On the one side, we have the case in which the reaction of wages is due to
changes in output and employment driven by changes in effective demand.
In such a case, to which the passage above refers, Keynes maintained that
rising nominal wages and falling real wages are likely to accompany increasing
output and employment; the opposite when output and employment are
decreasing.3
On the other side, there is the case in which changes in nominal wages are
not caused by changes in effective demand but, for instance, by changes in the
conditions governing wage bargaining.4 In this second perspective, Keynes
3
This implies that prices increase (decrease) more than wages when output increases
(decreases). In Keynes’s view this happens because there is a prevalence of increasing
costs in the short term of the upswing and a rise in the proportion of product going to
profits during expansion, while the reverse patterns of change characterise contractions in
output (see the letter from Keynes to Dunlop dated 1938 (Dunlop 1998, Appendix)).
4
Keynes specified that, in such a case, variations in nominal wages are not caused by
changes in effective demand but they may cause such changes (see Section 3 on this point).

6
argued that if a nominal wage reduction were to occur, real wages would
be unlikely to be reduced as neoclassical economists predicted. Considering
the economy as a whole, a nominal wage reduction that is not followed by
a price decrease implies a ‘fallacy of composition’. In this scenario, nominal
wage reductions would not tend to reduce unemployment, since the level of
real wages could remain largely unaffected.5 More in general, nominal wage
changes can produce complex effects on output and employment which are
difficult to generalise.
Keynes also provided a reason for the observation of downward wage
stickiness in the presence of excess supply of labour, in the circumstances of
British industrial relations between the two World Wars, which has been the
focus of discussion and criticism. In Keynes’s view, workers are concerned
not only with real wages but also with relative wages, that is with how their
pay compares with the pay of those to whom they regard themselves at least
equal in merit and status. However, if labour markets are disaggregated and
desynchronised, a nominal wage cut for a single worker or a group of workers
appears as a reduction in relative wage, since there is no guarantee that
other workers or groups of workers elsewhere receive the same cut. Hence, in
an economy characterised by decentralised wage bargaining, wage reductions
are only likely to occur by producing a final result which is “justifiable on no
criterion of social justice or economic expediency” (GT, p.267).
Summing up, Keynes explained the possibility of nominal wage downward
rigidity (at least over a certain range) in the presence of involuntary unem-
ployment with workers’ concerns about their relative wages. He postulated,
on the other hand, that, for a given technology, a rise in effective demand
would produce a fall in the real wage via an increase in the general level of
5
Hicks linked this event to what he termed Keynes’s ‘wage theorem’. In particular,
“When there is a general (proportional) rise [decrease] in money wages, says the theorem,
the normal effect is that all prices rise [decrease] in the same proportion whence the rate
of interest will be unchanged” (Hicks 1974, p.59, italics in original). (I am grateful to an
anonymous referee for reminding me of the passage quoted above.)

7
prices. This asymmetry led many critics to wonder why workers would accept
a cut in real wages effected by an increase in prices but resist reductions in
nominal wages, concluding erroneously that Keynes was attributing ‘money
illusion’ to workers (e.g. Leontief 1936).
In fact, from the theoretical viewpoint, the resistance to nominal wage
cuts and acceptance of reductions in real wages via a general rise in cost of
living is perfectly consistent with the goal of preserving the existing structure
of relative wages in disaggregated and desynchronised labour markets. Thus
workers are not behaving irrationally and no ‘money illusion’ phenomenon is
implied in Keynes’s argument (e.g. Trevithick 1992, pp.109-11). Moreover,
most recent findings on changes in pay over time also lend empirical support
to Keynes’s statement, since, although nominal wages are not completely
rigid downwards, they are somewhat sticky in the short term and are certainly
not all adjusted instantaneously to labour market changes; on the other hand,
real wages decreases are not rare (e.g. Blinder and Choi 1990; McLaughlin
1994; Card and Hyslop 1997). Of course, there could also be reasons other
than Keynes’s explanation for which nominal wages are downwardly sticky
and NKE has provided some contribution in this direction that shall be
discussed later. However, Keynes’s argument surely remains relevant.
A somewhat major problem with The General Theory refers to cyclical
behaviour of real wages. Keynes considered perfect competition in all prod-
uct markets6 but, as previously discussed, nominal wages were not perfectly
flexible. In this scenario, a combination of Marshallian product markets with
price-taking firms and neoclassical production technology as well as sticky
nominal wages imply that aggregate demand contractions during a reces-
sion are associated with a rise in real wages and the reverse patterns of
6
Although various reasons have been put forward to explain such a choice, the fact
that Keynes did not think imperfect competition altered his argument in any essential
way appears to be the most relevant. Indeed, Keynes’s theory of effective demand is
compatible with hypotheses other than perfect competition (e.g. Casarosa 1981; Shapiro
1997).

8
change will characterise expansions in aggregate demand and output, that is
real wages move counter-cyclically. Thus, Keynes and the neoclassical tradi-
tion in Cambridge had the same perspective of real wage behaviour during
economic fluctuations.7 In other words, Keynes refuted the second postu-
late of classical economics but accepted the first postulate “which classical
economists have (rightly) asserted as indefeasible” (GT, p.17).
As Dunlop (1938) and Tarshis (1939) first found, the problem here is
that this result has been repeatedly refuted by empirical observations. In
Dunlop’s 1938 article, the British experience for the period 1860-1937 was
summarised in the following passage:

Increases in [money] wage rates [during an upswing] have usually

been associated with increased real wage rates, while decreases in wage
rates have equally often been associated with a rise or fall in real wage
rates. (Dunlop 1938, p.421).

An alternative formulation concerning the contraction phase of the busi-

ness cycle stated that real wages rose in an initial phase of the downswing
in some cycles as nominal wages resisted reduction, and then in a second
phase real and nominal wages both declined (Dunlop 1938, p.425). Similar
results were found by Tarshis considering the U.S. experience for 1932-8, and
the current consensus (e.g. Mankiw 1990; Abraham and Haltiwanger 1995)
is that real wages appear to have no consistent relationship with economic
activity, or perhaps appear ‘slightly pro-cyclical’.
Indeed, Keynes received this evidence positively (albeit with some caveats)
and, in a long reply to Dunlop and Tarshis (Keynes 1939), admitted that in
The General Theory he was accepting, without taking care to check the facts
for himself, a belief which had been widely held by British economists. At the
7
However, Pigou in his Industrial Fluctuations reported that “the upper halves of trade
cycles have, on the whole, been associated with higher real wages than the lower halves”
(Pigou 1927, p.217).

9
same time, he specified that, if real wages do not move counter-cyclically, his
practical conclusions would have a fortiori force since it is possible to increase
employment without negatively affecting real wages.
In the same article, Keynes also listed different theoretical reasons for
the observation of a pro-cyclical behaviour of real wages.8 Particularly, if
the economy is in unusually deep recession, firms may be operating at lev-
els of output at which marginal costs are decreasing. However, Keynes was
very cautious in accepting diminishing marginal costs as a general charac-
teristic even if high levels of unemployment would occur in the economy.
Another important possible reason outlined by Keynes for real wage non-
countercyclical behaviour concerns the role of non-perfect competition and
sticky prices which were later to receive formal treatment from a strand of
NKE (see below). Nevertheless, in The General Theory a problem in de-
scribing the observed dynamics of real wages during business cycles does
remain.
Indeed this problem could be overcome by simply relaxing the assump-
tion that the capital stock is always fully utilized irrespective of the extent of
unemployment in the labour market. As Patinkin (1965) pointed out, during
a Keynesian recession capacity underutilization is typically observed side by
side with unemployed labour. This opens up the possibility of two alter-
native scenarios in which the counter-cyclical real wage dynamics does not
necessarily hold anymore. First, there could be various downward-sloping
labour demand schedules for different degrees of capacity utilization and a
8
In Keynes (1939) it is also remarked that Pigou, and many other classical economists,
maintained that an increase in effective demand, via public investment policies, would
indirectly reduce unemployment by deceiving workers into accepting a lower real wage.
Thus, it was the last that actually caused employment to rise (as a consequence, Pigou
and classical economists argued that the same result would has been more rapidly obtained
from a direct attack on real wages by reducing money wages). Keynes concluded that “If
the falling tendency of real wages in periods of rising demand is denied, this [Pigou’s]
alternative explanation must, of course, fall to the ground.” (Keynes 1939, p.40).

10
variation of capacity utilization over the cycle moves actual labour demand
schedule from one to another. Keynes, however, explicitly denied that the
labour demand schedule shifts over the business cycle due to fluctuations of
effective demand:

It is difficult to see a reason why [factors affecting the real labour

demand schedule] should change, except gradually over a long period.
Certainly there seems no reason to suppose that they are likely to
fluctuate during a trade cycle. [...] I should expect, therefore, that the
real demand for labour would remain virtually constant throughout a
trade cycle. (GT, p.279).

Thus, if (un)employment changes due to cyclical fluctuations of effective

demand but, as maintained by Keynes, the labour demand schedule cannot
shift because of those fluctuations, there remains a second alternative sce-
nario, namely the decline in effective demand does not only push workers off
their labour supply schedule, but it also pushes firms off their labour demand
schedule.9 In such a case, however, to account for fluctuations and persis-
tence in unemployment, it also has to be explained why price adjustments
fail to rapidly absorb those fluctuations and reduce unemployment. This
represents the major point in the NKE.
9
Alternatively, the two scenarios, which appear when the fully-utilized capacity hy-
pothesis is relaxed, can be described as follows. In the former, there is, in fact, a family
of marginal productivity curves, one for each level of capacity utilization (see McCombie
(1985) for a systematic treatment), while, in the latter, the marginal productivity prin-
ciple becomes irrelevant in periods of general unemployment and under-utilized capacity
(as is well known, this argument, originally proposed by Patinkin (1965), was later elabo-
rated and refined by the strand of the fixed prices and general disequilibrium models (e.g.
Malinvaud (1977)).
It is also worth noting that both scenarios maintain a Keynes’s insight abounding an
other. In particular, as specified above, the latter (but not the former) holds that the
labour demand schedule does not shift during the business cycle, while the former (but
not the latter) preserves the first postulate of classical economics since, for a given level
of capacity utilization, the real wage is equal to the marginal productivity of labour.

11
2.2 New Keynesian Economics
Turning to analyse the various New Keynesian theories on wage behaviour,
it is convenient to refer to the commonly-used classification, which divides
them into two more comprehensive groups: theories on real wage rigidity
and theories on nominal wage and price rigidity (e.g. Snowdon, Vane and
Wynarczyk (1994, Ch.7)).
New Keynesian theories on real wage rigidity aim to explain mainly the
presence and persistence of involuntary unemployment over time. Indeed,
New Keynesians regard this aspect as one of Keynes’s most valuable insights
(Greenwald and Stiglitz 1987, pp.120-1), but it is important to stress that
they tackle a somewhat different question than the traditional Keynes issue
concerning insufficient aggregate demand. They explain why, regardless of
the level of aggregate demand, labour markets do not clear at the microeco-
nomic level when there is (involuntary) unemployment. Indeed, in a single
labour market, if unemployed workers offered to work for less pay and firms
were willing to hire them at that lower pay, real wages would be bid down
and, with a standard downward-sloping labour demand schedule, employ-
ment would increase. Since Keynes provided no complete analysis of such an
issue, and as it is not clear whether workers’ concerns about relative wages
suffice to explain why unemployed workers do not offer to work for lower
pay than that actually paid to those employed10 , New Keynesians models on
real wage (downward) rigidity provide their own contribution by introducing
alternative (and more robust) explanations for such a phenomenon.
 
10 Wi Wi Wi Wi
Consider this utility function for worker i: ui P , Wj , with P and Wj which rep-
resent respectively her/his real wage and relative wage compared to a worker j. Assume
also that worker i reservation utility when s/he is unemployed is equal to ui . In this case,
when worker i is unemployed, s/he would not accept a nominal wage Wi′ < Wi only if
 ′   
W W′
ui Pi , Wij ≤ ui . However, if ui W Wi
P , Wj
i
> ui there could be a wage Wi′ for which
   ′ 
W W′
ui W Wi
P , Wj
i
> ui Pi , Wij > ui . In such a case, why does worker i not accept a (lower)
wage Wi′ when s/he is unemployed?

12
 In detail, efficiency wages and insider-outsider theories explain why firms
do not cut wages when there are unemployed workers. In an asymmetric in-
formation framework, efficiency wage models (e.g. Akerlof and Yellen 1986;
Weiss 1990) describe several reasons why cutting a wage adversely affects the
quality or productivity of labour and increases at the end its cost measured
in terms of efficiency units. The most important versions of this story fo-
cus on the effect on the distribution of workers hired (the adverse selection
effect) and the effect on the performance of individual workers (the incen-
tive or moral hazard effect). In insider-outsider theories (e.g. Lindbeck and
Snower 1990), insiders (incumbent workers) have some power in determining,
at least partially, firm’s wage and employment decisions due to the presence
of turnover costs. Since it is costly for a firm to exchange insiders for out-
siders (unemployed workers), the insiders can extract a share of the economic
rent generated by such turnover costs. Moreover, since in these models real
wages are (downwardly) rigid, economic shocks may have little or no effect
on the wage rate, but simply lead to variations in employment. Thus the
dynamics of real wages may show no systematic correlation with economic
activity, which is consistent with empirical observations.11
Although Greenwald and Stiglitz state that “Keynes attributed the per-
sistence of unemployment to the failure of wages to adjust with sufficient
speed to clear labour markets ... [and] efficiency wage [and insider-outsider]
models offer a compelling set of explanations for [this] critical Keynesian
contention ...” (Greenwald and Stiglitz 1987, p.121), there are substantial
differences between Keynes’s own theory and the New Keynesian models out-
11
However, some New Keynesian theories on real wage rigidity produce a real wage
dynamics which is too pro-cyclical and have been criticised because, as already discussed,
evidence suggests that the real wage rate is, if not a-cyclical, at worst ‘slightly’ pro-
cyclical. I refer in particular to the famous ‘shirking version’ of efficiency wage models,
due to Shapiro and Stiglitz (1984), in which the efficiency wage is sensitive to the rate of
unemployment and lower unemployment rates force firms to pay higher wages as a workers
discipline device (for a reply to such criticism see Stiglitz (1987, pp.36-7)).

13
lined above. In fact, both in Keynes’s and the New Keynesian framework
a decrease in the real wage rate is necessarily linked to an increase in em-
ployment, but the mechanism which underlies this relation differs markedly
in the two frameworks. Keynes, indeed, emphasised that the real wage is
not directly fixed by economic agents through bargaining12 and he asserted
that only a rise in the effective demand would determine, via an increase in
prices, a fall in the real wage rate (together with an increase in output and
employment). Literally, “The propensity to consume and the rate of new
investment [i.e. the effective demand] determine between them the volume
of employment, and the volume of employment is uniquely related to a given
level of real wages - not the other way round. (GT, p.30, italics added)13 .
Putting it another way, in Keynes’s view, the real wage rate is rigid only if
the level of effective demand is fixed. By contrast, in New Keynesian theories
of real wage rigidity, such rigidity is due to optimal (equilibrium) choices of
rational firms and workers. Thus policies to reduce the real wage rate must be
directed to modify microeconomic incentives for them (e.g. modifying social
institutions in the labour markets, increasing labour productivity, reducing
insiders’ power, etc.). On the contrary, these models largely leave unclear
the role (if any) for the aggregate demand. Therefore, while New Keynesian
models of real wage rigidity produce an unemployment equilibrium outcome
12
As Trevithick points out, “The impotence of the two parties [workers and employers]
to the wage bargain to bring about a reduction in the real wage is what makes Keynesian
unemployment involuntary” (Trevithick 1992, p.96, italics in original).
13
Keynes advanced this idea on many other occasions. For instance, in his memorandum
of 1930 to the committee of economists of the Economic Advisory Council, he asserted
that “Real wages seem to me to come in as a by-product of the remedies which we adopt
to restore equilibrium. They come in at the end of the argument rather than at the
beginning” and also “Employment is not a function of real wages in the sense that a
given degree of employment requires a determinate level of real wages, irrespective of how
the employment is brought about” [‘Memorandum by Mr J.M. Keynes to the commitee
of economists of the Economic Advisory Council’, p.180, as reprinted in Keynes (1973,
pp.178-200)].

14
which could be compatible with Keynes’s involuntary unemployment defi-
nition 14 , this outcome is much less in harmony with Keynes’s involuntary
unemployment theory since unemployment due to a real wage rate which is
too high as compared to the market-clearing value (without any clear rea-
son for this, which can be connected to effective demand deficiency) is more
similar to the classical than Keynesian concept of unemployment.15
While New Keynesian models of real wage rigidity deal with the persis-
tence of involuntary unemployment over time, the earliest NKE attempts to
provide rational microeconomic foundations to nominal wage rigidity relate
to the issue of why (output and) unemployment fluctuates (e.g. Mankiw
1990). I refer to the long-term and staggered wage contract models initially
proposed by Fischer (1977), Phelps and Taylor (1977) and Taylor (1980).
In these models, the presence of explicit (or implicit) labour contracts pre-
determining the nominal wage for an agreed period can generate sufficient
nominal wage inertia. However, a criticism levelled at this literature is that
the time between renegotiations is exogenously determined. Thus critics have
pointed out that the existence of such contracts and their expiry dates are
not explained by solid microeconomic principles. Ironically, these models
which aimed at providing microeconomic foundations to Keynes’s argument
14
Keynes’s famous (but also “extraordinarily convoluted” (Trevithick 1992, p.108)) def-
inition of involuntary unemployment is given on page 15 of The General Theory (all italics
in original):

Men are involuntarily unemployed if, in the event of a small rise in the
price of wage-goods relatively to the money-wage, both the aggregate supply of
labour willing to work for the current money-wage and the aggregate demand
for it at that wage would be greater than the existing volume of employment.

It is clear that in the New Keynesian models discussed above a real wage decrease leads
to a reduction of involuntary unemployed workers according to Keynes’s definition.
15
Indeed some authors (e.g. McCallum 1989; Zenezini 1997) have pointed out that,
although these models are labelled as ‘New Keynesian’, they are very close to classical
and new classical theories of unemployment.

15
of nominal wage stickiness have de facto proved less ‘micro-founded’ than
Keynes’s original explanation. Moreover, from the perspective of real wage
dynamics, these models have the same problem as Keynes’s original theory.
In particular, with sticky nominal wages and movements along a standard,
downward-sloping, labour demand schedule, a negative shock to aggregate
demand is characterised by a decrease in output, employment and prices,
and by an increase in real wages (since nominal wages are sticky). Thus the
contribution of these models in explaining the observed real wage behaviour
during the business cycles is negligible.
In this direction, instead, a real contribution has been provided by an-
other strand of NKE that turned the attention away from imperfections in
the labour market and toward those in the goods markets. In particular,
since evidence (e.g. Rotemberg and Woodford 1991) suggests that the ex-
pansion (recession) phase is associated with a decline (increase) in the degree
of monopoly (defined as the gap between price and marginal cost as a frac-
tion of price i.e. mark-up) in the goods markets, the assumption of free
competition in these markets needs to be relaxed for a more complete un-
derstanding of wages dynamics over business cycles.16 Thus, much effort of
NKE has been devoted to examining the behaviour of monopolistically com-
petitive firms in product markets which face small frictions such as ‘menu
costs’ or ‘near-rationality’ when they change prices (e.g. Mankiw 1985; Ak-
erlof and Yellen 1985; Blanchard and Kiyotaki 1987). These models seek to
explain, in rigorous microeconomic terms, the failure of price-maker firms
to restore equilibrium. In particular, when the shock is small, monopolisti-
cally competitive firms might not have the incentive to cut their prices when
demand for their goods declines because the benefit is small (second-order).
Yet, because of the preexisting distortion of monopoly pricing, the benefit for
society of a price cut may be large (first-order). In other words, with nom-
inal price rigidity, due to menu costs and/or near rationality, small shocks
16
Kalecki (1939) was the first to advocate the importance of this factor.

16
to nominal aggregate demand might cause large fluctuations in output and
employment.17 Moreover, these models do not imply a countercyclical real
wage. As firms have sticky prices, it is possible that they cannot sell all they
want at such prices if aggregate demand is reduced. This may move firms
off their (downward-sloping) labour demand schedule, leaving the path of
real wages indeterminate. Thus, once nominal price rigidity is considered,
real wages can also become a-cyclical (or ‘slightly’ pro-cyclical) as evidence
suggests.
As with the New Keynesian models of real wage rigidity discussed above,
there are also some important differences characterising NKE models which
explain nominal rigidities, both in wages and prices, with respect to Keynes’s
theory. First, in models of monopolistic competition and nominal price rigid-
ity, fluctuations in real output and employment are essentially due (for any
given path of nominal aggregate demand) to price stickiness while in such
models nominal wage behaviour is not so relevant in explaining those fluctu-
ations (Gordon 1990). Putting it another way, such New Keynesian models,
conversely from Keynes’s analysis, concentrate on nominal prices rather than
on nominal wages and say little about how wages are the dominant influence
on prices. Second, in New Keynesian models of nominal rigidities, without
such rigidities, flexible prices would be able to maintain full employment in
the economy. Although they do not analyse in detail specific mechanisms
by which falling wages and prices would ensure full employment, a sort of
hidden ‘real balance effect’ implicitly seems to appear in most of such mod-
els: if wages and prices fell, the real value of individuals’ holdings of money
17
In this direction, one important criticism of such an approach is that models with
nominal frictions can theoretically produce large nominal rigidities but do so for implausi-
ble parameter values, that is shocks must be too small and adjustments costs must be too
high to produce empirically observed behaviours and results. In response to this attack,
Ball and Romer (1990) have shown that substantial nominal rigidities can result from
a combination of real rigidities and small frictions to nominal adjustment, i.e. nominal
rigidities matter only if real rigidities matter.

17
would increase and this would induce them to consume more. No attention,
instead, seems to be ascribed to the impact of nominal price changes on ef-
fective demand via expectations behind the investment demand function and
the liquidity preference schedule. By contrast, such aspects play a central
role in Keynes’s opinion concerning the ability of flexible wages (and prices)
to restore equilibrium and maintain full employment in economic systems
facing shocks. Given the importance of this issue, the next section covers it
in greater detail.

3 Nominal Wage Flexibility and Full Employ-

ment
Keynes’s explanation of wage behaviour has been the usual focus of discus-
sion and criticism. However, Keynes followed this with another important
argument sometimes ignored by New Keynesians. In Chapter 19 of The Gen-
eral Theory (“Changes in Money-Wages”) he came to the dynamic effects of
downward nominal wage flexibility.
While neoclassical economists asserted that a reduction in nominal wages
is associated with an increase in employment, Keynes pointed out that “the
precise question at issue is whether the reduction in money-wages will or will
not be accompanied by the same aggregate effective demand as before” (GT,
p.259). In particular, he argued that, starting from an insufficient aggregate
demand and underemployment equilibrium, a policy of greater nominal wage
flexibility would be unlikely to generate forces powerful enough to lead the
economy back to full employment. On the contrary, the main result of this
policy would be to cause a great instability of prices “so violent perhaps as
to make business calculations futile in an economic society functioning after
the manner of that in which we live” (GT, p.269). In other words, wage
cuts were not the proper cure for unemployment and might not be a cure at

18
all.18 This led Keynes to conclude that a policy of stable rather than flexible
nominal wages is probably the best macroeconomic environment:

When we enter on a period of weakening effective demand, a sud-

den large reduction of money-wages to a level that no one believes
in its indefinite continuance would be the event most favourable to
a strengthening of effective demand. But this [...] is scarcely prac-
tical politics under a system of free wage-bargaining. On the other
hand, it would be much better that wages should be rigidly fixed and
deemed incapable of material changes, than that depressions should
be accompanied by a gradual downward tendency of money-wages ...
(GT, p.265)

and

In the light of these consideration, I am now of the opinion that

the maintenance of a stable general level of money wages is, on balance
of considerations, the most advisable policy for a closed system. (GT,
p.270)

Before moving on to analyse in detail Keynes’s reasons for the statements

quoted above, it is important to keep in mind that such a point, as made by
Keynes, is quite different from that of why labour markets do not clear at
the microeconomic level, which was discussed in the previous section referring
to New Keynesian theories of real rigidities in the labour markets. In The
18
In a conference meeting held in Chicago in 1931 Keynes explicitly asserted that “There
is scarcely one responsible person in Great Britain prepared to recommend [wage cuts]
openly.” [‘An economic analysis of unemployment’, p.360, as reprinted in Keynes (1973,
pp.343-67)]. In another influential article, in order to regain international price competi-
tiveness, reduce unemployment and improve the living standards of the working class, he
advocated relative (compared to labour productivity) instead of absolute wage reductions,
that is “squeezing the higher wages out of increased efficiency” [‘The question of high
wages’, p.11, as reprinted in Keynes (1981, pp.3-16)].

19
General Theory Keynes considered the effects of a nominal wage reduction
(or flexibility) for economy-wide markets. He argued that, while in an open
economy a reduction of nominal wages relative to nominal wages abroad
would be favourable to investment since it will tend to increase the balance
of trade (GT, p.262)19 , in a closed economy the way in which nominal wage
cuts would cure unemployment and return the economy to full employment
equilibrium could operate primarily through their impact on the interest
rate. Holding a nominal quantity of money constant, a decline in prices
which follows that of nominal wages will produce an increase in the real
quantity of money and then a decrease in interest rate. This will generally 20
lead to an increase in aggregate demand via investment expenditure which
could contribute to restore full employment. As Keynes gave such theoretical
importance to this effect, it is often referred to as the ‘Keynes effect’. In
sum, for Keynes the policy of allowing nominal wages to fall for a given
(nominal) money supply could, in theory, produce the same effects as a policy
of expanding the money supply with a given nominal wage. Since this was
the case, wage cutting was nevertheless subject to the same obstacles of
monetary policy as a method of securing full employment:

We can, therefore, theoretically, at least, produce precisely the

same effects on the rate of interest by reducing wages, whilst leaving
the quantity of money unchanged, that we can produce by increasing
the quantity of money whilst leaving the level of wages unchanged. It
follows that wage reductions, as a method of securing full employment,
are also subject to the same limitations as the method of increasing
19
At the same time, however, Keynes maintained that unemployment would be reduced
only in local industries competing with foreign suppliers while the overall effect on unem-
ployment would be more complex to predict. For reasons explained in the Introduction, the
analysis in this paper concentrates on a closed economy. Rohwedder and Herberg (1984)
provide a systematic treatment of the ‘production cost effect’ relative to the ‘purchasing
power effect’ in relation to a variation of nominal wages in an open economy.
20
This does not hold true if under-utilization of capacity exists.

20
 the quantity of money. (GT, p.266)

Keynes introduced two main theoretical reasons why the ‘Keynes effect’
might fail. First, if interest rates are very low the demand for money becomes
perfectly elastic with respect to interest rates. In this ‘liquidity trap’ case,
about which Keynes said that “whilst this limiting case might become prac-
tically important in future, I know of no example of it hitherto” (GT, p.207),
each real money supply increase is followed by a money demand increase of
the same amount. Thus, interest rate and investment expenditure do not
change. Second, the role of the business expectations (‘animal spirits’) and
the marginal efficiency of capital might render the investment expenditure
less sensitive, and perfectly inelastic at the extreme, to interest rates. In these
two cases, falling nominal wages and prices would be unlikely to stimulate
aggregate demand and increase output and employment.21 Keynes, however,
did not consider adequately another more direct effect that falling wages and
prices can produce, namely increasing real wealth in the form of increased
real value of base money, which in turn increases aggregate demand via a
rise in consumption expenditure and, possibly, also in investment expendi-
ture as wealth-owners seek to maintain portfolio balance between real and
nominal assets (Tobin 1993). This effect, commonly labelled as the ‘Pigou ef-
fect’ or ‘real balance effect’ (Pigou 1943, 1947; Patinkin 1948)22 , clearly does
not depend on reduction of interest rates. Thus, after the Second World
War, Neoclassical Synthesis economists have interpreted and presented The
21
As is well known, during the 1960s the ‘neoclassical synthesis’ incorporated these two
cases in the IS-LM model as special or limiting cases: a perfectly horizontal LM for the
liquidity trap case and a perfectly vertical IS for the interest-inelastic investment case.
22
Some authors (e.g. Presley 1986) have suggested that Keynes anticipated the real
balance effect but rejected it on both theoretical and practical grounds (see also Kalecki
(1944) for a theoretical attack on the real balance effect). Also Patinkin (1948), who
conversely stressed its theoretical importance, disclaimed belief in its practical significance
pointing out that in the Great Depression the real value of net private balances rose by
46 percent from 1929 to 1932 but real national income fell by 40 percent.

21
General Theory as a special case in which downward nominal wage rigid-
ity is necessarily required to prevent the neoclassical automatic adjustment
to full employment (see, in particular, Modigliani’s ground-breaking article
(Modigliani 1944)).
Indeed, the most important point, which has been too often forgotten over
time by a number of (old and new) Keynesian economists, is that Keynes did
not himself stop to consider the two special cases in which the standard ‘wage
reduction remedy’ does not work. He also proposed the stronger argument
that greater wage flexibility might be even a self-defeating way to achieve
equilibrium at full employment. In particular, Keynes focused on the role of
economic agents’ expectations:

If the reduction of money-wages is expected to be a reduction rel-

ative to money wages in the future, the change will be favourable to
investments because [...] it will increase the marginal efficiency of cap-
ital; whilst for the same reason it may be favourable to consumption.
If, on the other hand, the reduction leads to the expectation, or even to
the serious possibility, of a further wage reduction in prospect, it will
have precisely the opposite effect. For it will diminish the marginal
efficiency of capital and will lead to postponement of both investment
and consumption. (GT, p.263, italics in original)

The adverse effect on the investment expenditure of a reduction in nom-

inal wages which leads to the expectation of a severe deflation of prices in
the future may be better understood if we consider the well-known Fisher
equation which states that the (expected) real interest rate is (approxi-
mately) equal to the nominal interest rate minus the expected rate of in-
flation (r e ≃ i − π e ). Greater expected deflation (π e < 0) can produce an
increase in the real rate of interest, which is business’s real cost of borrow-
ing, and it is necessarily so when nominal interest rates are constrained by
the zero floor of the interest on money. Of course, Keynes stressed that such

22
a problem does not emerge if a nominal wage reduction is believed to be one
in which nominal wages have touched the bottom, “so that further changes
are expected to be in the upward direction” (GT, p.265). At the same time,
he also suggested that a large reduction in nominal wages to such a low level
would be difficult to achieve in a system of free and desynchronised wage
bargaining.
The impact of severe deflation on the propensity to consume and invest
was also likely to be adverse due to the distributional effect that such deflation
produces (GT, pp.262-4). In particular, the net effect of transfers from wage-
earners to other factors and from entrepreneurs to rentiers is more likely to
be negative on the propensity to consume. Generally, as long as debtors
are able to repay their obligations,23 price declines make creditors better off
and debtors poorer, but their respective marginal propensities to spend need
not be the same and common sense suggests that debtors have the higher
spending propensities (that is why they are in debt!).24 Distributional effects
are likely to be adverse also for investment expenditure since deflation mainly
penalises highly leveraged firms and this could produce negative effects for
the financial system, reducing banks’ propensity to finance new investments
(GT, p.264-7).25
23
If this is not the case (i.e. danger of bankruptcies), declining prices may produce even
more disastrous effects, as we shall see below.
24
This point was emphasised before Keynes by Fisher (1933), who indicated the in-
creased burden of debt resulting from unanticipated deflation as a major factor in de-
pressions in general and in the Great Depression in particular. For such a reason, Tobin,
who more recently analysed this issue formally (Tobin 1975; 1980, Ch.1), defined it as the
Fisher, or ‘reverse’ Pigou-Patinkin, effect (not to be confused with the other Fisher effect
discussed above). In particular, Tobin pointed out that if inside assets and debts wash
out in accounting aggregation does not mean that the consequences of price changes on
their real values wash out. This is because marginal propensities to spend from wealth
need not be the same for creditors and debtors. Moreover, “[many debtors] are liquidity-
constrained, and as their debt/equity ratios increase their credit lines dwindle or, in case
of bankruptcies, disappear” (Tobin 1975, p.197).
25
Keynes advanced this point in more detail also in ‘The economic consequences to the

23
 In conclusion, in Keynes’s own view, a reduction in nominal wages can
help to bring about recoveries if it is believed to be temporary and that it will
be quickly reversed. On the contrary, if it leads to the expectation of future
severe deflation, and the negative effects explored above outweigh the real
balance and Keynes effects combined (this is quite possible particularly when
output and employment are low relative to capacity (e.g. Tobin 1980, Ch.1)),
aggregate demand will decrease rather than increase since both consumption
and investment expenditures are discouraged or postponed. In other words,
economic agents’ pessimism will turn recession into depression. Moreover,
fluctuations of prices and instability of short-run employment equilibrium
would be reduced with a rigid (nominal) wage policy (GT, p.271).
Although during the late 1970s and early 1980s some economists re-
explored the notion that wage and price rigidity is not the only problem
and perhaps not even the main problem,26 most New Keynesians seemed
not to take into account such prominent messages. Indeed, the enormous
importance ascribed by some New Keynesians to nominal wage and price
rigidities would not find valid justification if such rigidities were not believed
to be the main causes of the persistence and fluctuations of unemployment
over time (i.e. increasing wage and price flexibility would produce positive
effects). Hence, this strand of NKE completely ignores Keynes’s concerns
about the possibility that nominal wage reductions were not the proper cure
for unemployment.
There are, however, some other New Keynesian theories which, albeit
with substantially different features, seem to reinforce Keynes’s opinion on
banks of the collapse of money values’ [as reprinted in Keynes (1972, pp.150-8)].
26
Tobin’s works have been already cited and discussed (see footnote 24). He also re-
marked that Keynes “was well aware of the dynamic argument that declining money wage
rates are unfavourable to aggregate demand. But perhaps he did not insist upon it strongly
enough, for the subsequent theoretical argument focused on the statics of alternative stable
wage levels” (Tobin 1975, p.195). Other notable works in the same vein are Hahn (1984),
Schultze (1985), Hahn and Solow (1986) and De Long and Summers (1986).

24
this issue. In particular, Greenwald and Stiglitz (1993a,b) have been influen-
tial in developing New Keynesian models which do not rely on nominal price
and wage inertia (although real rigidities play an important role):

A number of facts imply that price rigidities are, at a minimum,

not the only source of economic problems [...] For example, Keynesian-
like unemployment problems seem to arise even in economies which
are experiencing inflationary pressures, and thus where the nominal
wages do not need to fall, but only to rise more slowly. Moreover,
nominal wages and prices did fall in the Great Depression [...] We
agree with Keynes that had prices fallen even faster, the economy
would have degenerated farther, rather than improving more quickly.”
(Greenwald and Stiglitz 1993b, p.36, italics in original)

The authors consider risk-averse firms which, due to the presence of finan-
cial market imperfections generated by asymmetric information and incom-
plete contracts, are constrained in accessing equity finance. Their resultant
dependence on debt rather than new equity issues makes firms more vul-
nerable to bankruptcy, especially during a recession. In such a situation a
risk-averse equity-constrained firm prefers to reduce its output because the
uncertainties associated with price flexibility are much greater than those
from quantity adjustment. Greenwald and Stiglitz argue that, as a firm pro-
duces more, the probability of bankruptcy increases and since bankruptcy
imposes costs, these will be taken into account in firms’ production deci-
sions. Indeed, in such a framework, nominal price and wage flexibility, by
creating more uncertainty, would in all likelihood make the situation worse,
inducing firms to further reduce output and employment. For instance, an
unanticipated wage-price reduction might actually serve to exacerbate a re-
cession, rather than recover economic performance, by worsening the working
capital base of firms and making them more reluctant to produce, if they be-
lieve current declines in prices will continue in the future (Greenwald and
Stiglitz 1987, pp.127-32).

25
 Some ingredients of this theory ‘of the risk-averse firm’ seem to be consis-
tent with an important feature of Keynes’s original thought. In particular, as
already discussed, Keynes pointed out that an incisive nominal wages decline,
by determining a decline in product prices, may have large adverse effects on
profits and financial position (or liquidity) particularly for highly leveraged
firms. As a consequence, lenders, particularly banks, face the risk that loans
will not be repaid. Moreover, if also banks are highly leveraged, the risk of
bankruptcy increases also for them and the overall financial system would
suffer, with consequent disastrous effects on output and employment. This
story plays a central role in the Greenwald-Stiglitz framework:

[The theory of the risk averse firm] contains three basic ingredients
[...]: risk averse firms; a credit allocation mechanism in which credit-
rationing, risk-averse banks play a central role; and new labor market
theories, including efficiency wages and insider-outsider models. These
building blocks should help to explain how [wage and] price flexibility
contributes to macroeconomic fluctuations and to unemployment. In
particular, the first two blocks will explain why small shocks to the
economy can give rise to large changes in output, while the new labor
market theories will explain why those changes in output [...] result
in unemployment.” (Greenwald and Stiglitz 1993b, p.26)

In particular, as emerges from the statement quoted above, the first two
blocks come close to Keynes’s original idea, enriching it with recent devel-
opments obtained by modern theories of credit markets with asymmetric
information and credit-rationing (Greenwald and Stiglitz 1987). At the same
time, however, the framework outlined by Greenwald and Stiglitz presents
an important distinguishing feature. In particular, the third block explicitly
refers to the New Keynesian theories of the labour market, discussed in Sec-
tion 2.2, in which (involuntary) unemployment is strongly founded on real
wage rigidity. However, for reasons that have been outlined above, those

26
theories markedly differ from that of Keynes in some important aspects.
Most of all, Keynes assigned no central role to wage rigidity in theoretically
explaining the presence and persistence of involuntary unemployment.

4 Concluding Remarks
This paper has described and compared different contributions of NKE with
respect to Keynes’s original work on wages and unemployment, pointing out
the major differences and similarities.
Like Keynes, New Keynesians also consider persistent involuntary un-
employment as being a central and continuing problem. At the same time,
referring to the role of nominal and/or real wages behaviour in explaining
unemployment, New Keynesian theories present important features which
differ, sometimes substantially, from the ideas and concepts developed by
Keynes in his General Theory.
In particular, in Keynes’s view real wages would be ‘adjusted’ according
to the level of employment corresponding to the actual amount of effective
demand. Thus, according to Keynes, effective demand determines the real
wage rate as well as output and employment. At the same time, he denied
any direct influence of the real wage on (un)employment and he believed that
nominal wage cuts (or flexibility) was not the main cure for unemployment,
and might not be a cure at all.
By contrast, modern New Keynesian theories of the labour market (e.g.
efficiency wages and insider-outsider) emphasise the role of real wage rigidity
in explaining involuntary unemployment, while those which stress the role of
nominal rigidities, both in wages and prices, do not seem to take into account
Keynes’s concerns about the possibility that greater nominal flexibility could
exacerbate the economy’s downturn and increase unemployment. In this last
direction, however, there are some New Keynesian models which seem to
reinforce Keynes’s opinion, albeit with major distinguishing features.

27
 In conclusion, NKE has restored to favour typical Keynesian arguments
that seemed to be forgotten during the 1970s, namely skepticism in the abil-
ity of the market’s invisible hand to maintain full employment. It has also
provided new contributions on some issues that, with respect to Keynes’s
work, should be investigated in greater detail (e.g. the role of imperfect
competition in goods and labour markets). At the same time, NKE does
not fully incorporate some of Keynes’s greater insights. Too often the only
Keynesian characteristics of New Keynesian models are the final results (i.e.
persistent unemployment and economic fluctuations), while everything else
remains largely neoclassical. In particular, Keynesian results are obtained
by introducing (with robust and well-defined micro-foundations) some im-
perfections, namely nominal and/or real rigidities in wages (and prices),
which hamper de facto classical adjustment processes to full employment.
By contrast, Keynes’s final results were obtained in a different theoretical
framework in which (nominal and real) rigidities did not play any central
role. Furthermore, in some cases New Keynesian theories seem also to join
traditional neoclassical economics in suffering from a ‘fallacy of composition’,
in the sense that their wholes are simply the sum of their parts and, as a con-
sequence, some major effects deriving from interaction among different parts
remain hidden from analysis, something Keynes would never have done!

28
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