Labor market

Labor supply and labor demand in the Keynesian model

Remember that the supply of labor, LS(W/P), depends positively on real wages in the classical model. It is not always clear which individuals are included in the labor supply. The labor supply may consist of only individuals in the workforce or it may have a wider definition including individuals that are outside the labor force but would like to work if they could find a job. The second category may contain so-called "discouraged workers" and individuals that are in school but who would rather work.

The Keynesian labor supply differs from the classic labor supply in that it includes individuals that are outside the workforce. Therefore, for a given real wage, the Keynesian labor supply is larger than the classic labor supply. However, the Keynesian labour supply is still a positive function of the real wage.

The demand for labor LD(W/P) is the same as for the classical model. It is derived from the marginal product of profit maximizing firms. The following graph shows the classical labor supply, the Keynesian labor supply and the labor demand.

Classical and Keynesian labor supply.

Fig. 11.5: Classical and Keynesian labor supply.

Note that for the classical equilibrium real wage, the Keynesian supply exceeds the demand. In the Keynesian models, we do not assume that the real wage will be equal to the equilibrium real wage. The labor market need not be in equilibrium in the classical sense. However, in the Keynesian models, the real wage is such that there is always an excess supply of labor (using the Keynesian supply).

The labor in the cross model

In the cross model, both P and W are constant and exogenous. Therefore, the real wage is constant and it is not necessarily equal to the equilibrium real wage. The model of the labor market in the cross model can be illustrated by the following figure:

The labor market in the cross model

Fig. 11.6: The labor market in the cross model

Aggregate supply

Remember that labor demand gives us the profit-maximizing quantity of L for a given real wage. If W/P is given (as it is in cross model), we can find the profit-maximizing quantity of L from the graph. We denote this by LOpT. If firms use LOpT amount of labor, they will produce YOpT = fLOPT, K) where f is the production function and K the amount of capital (exogenous).

profit-maximizing quantity of L and Y.

Fig. 11.7: profit-maximizing quantity of L and Y.

An important assumption in the cross model is that YOpT is always larger than YD - the aggregate demand is not sufficient for the amount that firms would like to supply at the given real wage. This assumption has a very important consequence. Even though producing YOpT would maximize profits, firms will not produce this level due to the lack of demand. They will only produce YD and we see why it is aggregate demand that is important in the cross model. Again, note how the Keynesian cross model works with quantity adjustments instead of price adjustments as in the classical model. We denote the level of output produced by the firms by Y*.

Determination of L in the cross model

Since firms will produce less than YOpT, they need less labor than LOPr We can figure out exactly how much L they need in order to produce Y* and this level of L is denoted by L*.

Determination of L in the cross model.

Fig. 11.8: Determination of L in the cross model.

1. Start at the bottom left. Here, the equilibrium level of GDP (denoted by Y*) is determined. We can add Y* on the y-axis as well since YD = Y* in equilibrium.

2. Extend Y* to the bottom-right graph. This is the aggregate supply.

3. From the production function we can figure out exactly how much labor we need to produce Y*. This amount is denoted by L*.

4. Extend L* up to the upper right-hand graph. Since real wage is fixed, we must be on the horizontal line and we find the equilibrium for the labor market.

5. In the same diagram you will also find also find LOpT, the quantity of labor firms would choose if aggregate demand was sufficient.

Note a crucial difference between the classical and the Keynesian model: in the classical model we first determine L and go from L to Y while in the cross model we go from Y to L.

Equilibrium analysis

An important question is whether the equilibrium we have identified in the labor market (with a high unemployment rate) can remain in the long run. Will there not be adjustments that will take us back to a point with no unemployment? The Keynesian justification for why unemployment will persist is as follows.

The goods market is in equilibrium since firms will sell everything they produce and the demand for finished goods is satisfied. Firms then have no reason to hire more labor (they will only increase L when YD increases). And since the goods market is in equilibrium, they have no reason to change prices.

However, we have involuntary unemployment in the diagram above which may create a downward pressure on wages. In the cross model, this will not happen for the following arguments:

1. Nominal wages are sticky, particularly downwards. We hardly ever observe cuts in nominal wages.

2. Nominal wage cuts would not help. With lower wages, income would fall, reducing aggregate demand even more, making the situation worse. Lower nominal wages would allow firms to lower prices. But if prices fall as much as nominal wages, real wages will no, and we had stayed in the same paragraph.

As with the classical model, we study most of the check model characteristics in an exercise book. A couple of comments, however, may be of interest already here.

• It is difficult to explain long periods of high unemployment in the classic model with the model of labor used there.

• During the Great Depression in the early 1930s (the great depression), it became increasingly evident that the traditional model had flaws. Unemployment was very high for a long time and any adjustment to the balance of the labor market was not.

• In the Keynesian model, can the economy to be in balance even with a high level of involuntary unemployment and the model appeared to be a good explanation for depression.

• I check the model, financial policy is a very important role. By increasing G so, the government can increase GDp and thus reduce unemployment.

• The classic dichotomy between real and nominal variables will disappear in all Keynesian models.

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