Effective Demand And The Labour Market

Noah Smith asks, “Why the 101 model doesn’t work for labor markets”.

He realizes the answer but attributes it to Nick Hanauer. Smith says:

And with labor markets, it’s very hard to find a shock that only affects one of the “curves”. The reason is because almost everything in the economy gets produced with labor. If you find a whole bunch of new workers, they’re also a whole bunch of new customers, and the stuff they buy requires more workers to produce. If you raise the minimum wage, the increased income to those with jobs will also boost labor demand indirectly (somehow, activist and businessman Nick Hanauer figured this out when a whole lot of econ-trained think-tankers missed it!).

So Smith indeed concedes that the profession missed it out. But the attribution is incorrect. All this was figured out by Michal Kalecki in the 1930s.

Economists use supply-demand curves all the time without realizing that the diagram really doesn’t have time in it. Also, supply demand analysis crucially misses out the fact that supplies and demands are brought into equivalence not only because of “price clearing” but also quantity clearing. So while the supply-demand analysis is correct, it should be used more carefully.

So increases in real wages raises consumption and this leads to higher production plans which requires more labour. So because of the principle of effective demand, the reverse of what the New Consensus Economics says is true.

And also—without proof—it should be easy to see this in a stock-flow consistent model. Raise the wage rate and see the effect on output and employment. As simple!

But may be not. If say only the minimum wage is raised, although unemployment will fall in the short run, medium and long run effects can still be either way. So if fiscal policy is not relaxed, i.e., say, the growth rate of government expenditure is not increased, a rise in output will result in a rise in tax flows to the government and this may cause a slowdown in the rise of private sector wealth, resulting in a fall in output in the medium run. So fiscal policy also needs to be relaxed. Moreover, in the case of an open economy, faster rise in the wage rate may result in a fall in “price competitiveness”, and result in a fall in exports. A rise in a minimum wage in one region—say a state in the United States—may lead to a transfer of business operations to another state or even offshoring. So a global policy response is needed in the long run.

At any rate, we are far from the simplification of New Consensus Economics which starts off with a rise in unemployment due to a rise in real wage rises. The short run effect is completely the opposite.

Leave a Reply

Comments are welcome, but not published—see comments policy. Required fields are marked *