Price Flexibility and Output Stability: An Old Keynesian View 49 microeconomic flux Demands and supplies are continually shifting, bringing unemployment and excess capacity in some sectors and contemporaneous labor shortages and capacity bottlenecks elsewhere. The gross aggregates of these frictional excess supplies and excess demands vary together positively over time. In contrast, cyclical excess supplies and demands are negatively corre lated; in economy-wide recessions and depressions, excess-supply markets and sectors predominate, while the reverse is true in inflationary booms. The amount of frictional unemployment depends on the strength of intersectoral shocks and on the mobility of factors of production in responding to them Large and protracted shocks, for example in technology or in supplies and structural unemployment. Neither is remediable by demand expansion aloe a prices of key commodities like energy, convert frictional unemployment A common species of classical unemployment occurs when jobs are limited ecause of excessive real wage rates imposed by governmental or trade union regula tions For individuals who would like to work at or below the wage floor, such unemployment is involuntary. For the workers collectively whose bargain ing strength or political clout established the regulations, the unemployment could be regarded as the voluntary consequence of their exercise of monopoly power Identification of observed unemployment as classical or Keynesian is some times difficult. In either case unemployment might be observed to be associated with real wages above their full employment equilibrium values. In the Keynesian case, this could result from perfect competition among producing firms; they would be paying workers the high marginal products associated with low employment. The big difference between the two cases is that in the Keynesian case, but not in the classical case, real wages would decline on their own and output and employment would increase in response to expand demand. In the classical case removal of the regulations would be essential There are several variations on the classical unemployment theme. One case is queuing for a high-wage job. An artificially high wage in a particular sector could draw workers from employment elsewhere to wait and hope. This model was originally designed to explain the heavy unemployment in the urban centers of developing countries, where the queuing requires living near the scarce jobs, far from alternative means of subsistence in traditional agricul ture. It fits less well in advanced economies where workers can search and apply for better jobs while employed. Another source of voluntary unemploy ment may be unemployment insurance benefits and other transfers that in rease the reservation prices of persons without jobs. However, in the United States, where unemployment is measured by large household surveys con ducted monthly by the Census, persons without jobs will be counted not as unemployed but as"not in labor force unless they report they have been actively searching. Although some misreporting doubtless occurs, it is small,not always in the same direction, and cannot begin to account for the cyclical variability of unemployment rates
50 Journal of Economic Perspectives Agents who are unable to sell as much as they would like at prevailin prices restrict demands in other markets. Unemployed workers cut their consumption. Demand-constrained firms restrict their hiring of labor and their purchases of other inputs. Keynes' insight that quantities actually sold, if maller than sales desired at existing prices, will keep demands in other markets below equilibrium values, was rediscovered and elaborated by self-styled disequilibrium theorists"30 years later(Barro and Grossman, 1971). In old Keynesian economics, multiplier theory formalized the determination of quar tities by quantities. It did not and does not, however, preclude the relevance of other determinants of demand notably prices and interest rates. In this respect it is more general than most of its latter-day extensions in "disequilibrium heory. "In demand-constrained regimes, any agent,s increase in demand-for example, more investment spending by a business firm-has positive externai ties. It will increase the attainable consumption of third parties. In some modern literature, this idea of Keynes is revived and elaborated under the lal strategic complementarity"(Cooper and John, 1988) Liquidity constraints are an important but extreme form of effective de- mand constraint. Some wage earners, no doubt, depend on each week,s wages to buy the goods for that week,s consumption. But Keynes' principle does not depend on such short horizons for consumption-smoothing. Expectations of future spells of unemployment, enhanced by present and recent experience, can limit the current consumption and durables purchases even of long horizon households. Liquidity constraints and prospective effective demand constraints can also limit business investment. Common observation suggests that households and businesses, and governments too, differ ly in their horizons, i. e. the length of the future period over which expected resources are egarded as potentially available for spending today. These hor rizons. more over, doubtless change over time with circumstances and behavior. The multipliers relating change in aggregate demand to demand shocks from policies or other events, are not as large as they were thought to be when the concept was first introduced and estimated in the 1930s. One reason is a substantial structural change in democratic capitalist economies. Governments are much larger relative to private sectors than before World War Il, and their fiscal institutions are"built-in stabilizers. " Their expenditures are quite unre- sponsive to current business conditions, while their revenues (net of transfers to the private sector) are cyclically sensitive and thus moderate swings in private incomes. A second reason is that economists have come to recognize that thanks to accommodating capital markets as well as to their own foresight, most economic agents have horizons longer than one year. While this consideration implies that multipliers of transient shocks are lower than for permanent changes, it by no means implies that they are zero Both consumption and investment appear to be sensitive to contemporaneous and recent incomes. For most agents capital markets are far from perfect; in particular future and current labor incomes are not fungible. Moreover
James Tobin 51 expectations of economic futures, individual, national, and global, are inft enced by current events, perhaps to an irrational extent. As Keynes explicitly observed, his theory refers to economies with incom- plete markets. In his day futures markets were rare, and contingent futures markets even rarer. They are still scarce. As Keynes explained, decisions not to spend now are not coupled with any definite orders for future or contingent deliveries. Typically they result in accumulations of assets that can be spent on anything at any future time. The multiplier effects of lower current spending propensities are not offset by specific and firm expectations of higher future eman Business Cycles as Demand Fluctuations According to Keynesian macroeconomics, business cycles are fluctuations in aggregate effective demand, carrying output and employment in their wake. They do not reflect movements in market-clearing supply-equals-demand rla Supplies of labor and other factors of production move fairly smoothly from year to year and from cycle to cycle. So does economy-wide factor productivity, largely reflecting technological progress. Equilibrium output and employment cannot be as variable as actual cyclical observations. In the neoclas- sical neo-Keynesian synthesis, trend growth is supply-determined; markets are cleared; supply truly creates its own demand. In cyclical departures from trend demand evokes its own supply. Keynesian short-run macroeconomics does not pretend to apply to problems of long- run growth and development Equilibrium cycle theories(Plosser, 1989) are unconvincing. They rely on incredible volatili hnology, retrogressive as well as progressiv rely on extreme intertemporal substitutions among work, leisure, and con- sumption. Or they contrive informational asymmetries and misperceptions that seem easy to correct. For example, a few years ago a popular theory attributed business cycles to confusions by suppliers of products and labor between increases in their own real prices, on the one hand, and economy-wide infla tion, on the other. Evidently businesses and households were assumed to ignore the food of current statistics on prices and money supplies I am using the word equilibrium to mean Walrasian market-clearing by prices, as is the current usage of both new classical macroeconomists and isequilibrium theorists. Keynes used it otherwise, to refer to a position of rest. That is why he referred to outcomes with involuntary unemployment as equilibria on a par with full employment, and why he termed his the general"in the title of his book. The basic issue is not semantic. It is whether situations of general excess supply can and do exist for significant periods of ime, whether or not they are called equilibria
52 Journal of Economic Perspective Some passages of The General Theory can be read to assert that involuntary unemployment is much more than a temporary cyclical phenomenon, that it is in the absence of remedial policies a chronic defect of capitalism. This was a atural enough view in the 1930s. In Alvin Hansen's American Keynesianism (e. g, Hansen, 1938)secular stagnation was a central proposition. Formally, however, the analysis of The General Theory is limited to a time period short enough that the changes in capital stock resulting from non-zero investment can be ignored Postwar Keynesians, for the most part, have not regarded protracted depression as a likely outcome. Chronic inflationary gaps could also occur, and alternations between excess-supply and excess-demand regimes were highly probable. Keynesian macroeconomics is two-sided. Deviations on both sides of Walrasian market-clearing can occur, though not necessarily with symmetrica symptoms. Excess demand in aggregate is mainly an"inflationary gap, gener ating unfilled orders and repressed or open inflation, rather than significant extra output and employment. Macroeconomic stabilization requires two-sided countercyclical demand management. In any case, habitual application of Keynesian remedies reinforces what- ever natural mechanisms tend to return the economy to its full employment growth path. Expectations that those remedies will be used contribute to the stability of that equilibrium path The Efficacy of Classical Adjustment Mechanisms: Interest Rates uppose that shocks to current real demands for goods and services create, at existing prices and wages, excess supplies of labor and capital services. What are the variables whose changes would avert or eliminate macroeconomic disequilibrium? The leading candidates are current prices, which include both wages of labor as well as prices of products, and interest rates, which involve future as well as current prices. In what follows, I shall set forth Keynesian skepticism regarding the efficacy of these classical adjustment mechanisms If these mechanisms respond instantaneously to shocks, no actual discrep ancy between demand and supply will occur or be observed. The shocks will be wholly absorbed in the market-clearing variables. This is the assumption of equilibrium business cycle theory and of the"real business cycles"approach. It this assumption that, among other things, enables new classical macro- economists to dismiss out of hand real aggregate demand shocks and to react In Tobin(1955), stagnation is one possibility, the stable solution of a non-linear model whose