What flaws did Keynes find in the classical theory’s wage-flexibility argument?
The correct answer and explanation is :
John Maynard Keynes, in his work “The General Theory of Employment, Interest, and Money” (1936), challenged many of the assumptions put forth by classical economics, particularly the argument that wage flexibility ensures full employment. Classical economics posited that if unemployment occurred, wages would fall, leading to an increase in demand for labor, thus restoring full employment. Keynes found several flaws in this argument, primarily based on his understanding of how economies function during periods of economic downturn.
1. The Assumption of Perfect Wage Flexibility:
The classical theory assumes that wages can easily adjust in response to unemployment. However, Keynes argued that wages are not as flexible as classical economists assumed. He believed that wages, particularly nominal wages, are sticky downward, meaning that even in the face of rising unemployment, workers and employers are reluctant to reduce wages. This rigidity occurs due to factors such as contracts, social and political resistance to wage cuts, and the belief that reducing wages could demoralize workers.
2. The Role of Aggregate Demand:
Classical theory assumed that the economy would always adjust to a full-employment equilibrium through wage adjustments. Keynes, however, emphasized that aggregate demand (the total demand for goods and services in an economy) plays a crucial role in determining employment levels. If aggregate demand is insufficient, there can be widespread unemployment even if wages adjust downward. In such a scenario, lowering wages may not lead to increased employment, as the reduced wages could lead to a further reduction in demand for goods and services, resulting in even higher unemployment.
3. Unemployment as a Disequilibrium Phenomenon:
Keynes disagreed with the classical notion that unemployment is simply a temporary disequilibrium that would automatically be corrected by wage adjustments. He argued that unemployment could persist for long periods because of insufficient aggregate demand, which would not necessarily be corrected by wage changes alone.
In summary, Keynes rejected the classical argument that wage flexibility would automatically restore full employment. He believed that wages were sticky and that the key to solving unemployment lay in boosting aggregate demand, not relying solely on wage adjustments.