ECON102: Principles of Macroeconomics (2021.A.01)

During the Great Depression, classical theory defined economic collapse as simply a lost incentive to produce. Mass unemployment was caused only by high and rigid real wages.

The Keynesian relation between income and employment depends upon the assumption that the techniques (or technologies), the quantity and quality of equipment, and the efficiency and wage rate of labor are fixed over long periods.

In other words, "the assumption of constant money wage rates means that in the Keynesian model, an increase in expenditures can only increase employment if money wage rates do not rise and employment can only increase if real wage rates (i.e. wage rates relative to prices and to profits) fall". In this, his theory agrees with classical economists. On the other hand, both Keynesians and liberal economists recognized that money wage rates, particularly since the advent of the New Deal, are no longer free to fall due to monopolistic governmental and trade union control of the labor market.

To Keynes, nominal wage cuts would be difficult to put into effect because of laws and wage contracts. Even classical economists admitted that these exist; but unlike Keynes, they advocated abolishing minimum wages, unions, and long-term contracts, increasing labor-market flexibility. Keynes, however, argued that people will resist nominal wage reductions, even without unions, until they see other wages falling and a general fall of prices.

Keynes also argued that to boost employment, nominal wages would have to fall more than prices. However, doing so would reduce consumer demand, so that the aggregate demand for goods would drop. This would in turn reduce business sales revenues and expected profits. Investment in new plants and equipment – perhaps already discouraged by previous excesses – would then become more risky, less likely. Instead of raising business expectations, wage cuts could make matters much worse.

Further, if wages and prices were falling, people would start to expect them to fall. This could make the economy spiral downward as those who had money would simply wait as falling prices made it more valuable – rather than spending. As Irving Fisher argued in 1933, in his Debt-Deflation Theory of Great Depressions, deflation (falling prices) can make a depression deeper as falling prices and wages made pre-existing nominal debts more valuable in real terms.