A vital question is whether the equilibrium we have identified in labor market (with a high unemployment rate) can remain in long run. Will there not be adjustments which will take us back to a point with no unemployment? Keynesian justification for why unemployment will persist is as below.
Goods market is in equilibrium as firms will sell everything they produce and demand for finished goods is satisfied. Firms then have no reason to hire more labor (they will just increase L when YD increases). And as the goods market is in equilibrium so they have no reason to change prices.
Anyhow we have involuntary unemployment in the diagram above which may create a downward pressure on wages. In the cross model, this won't happen for the below arguments:
1. Nominal wages are sticky, principally downwards. We barely ever observe cuts in nominal wages.
2. Nominal wage cuts wouldn't help. With lower wages, income would fall, decreasing aggregate demand even more hence making the situation worse. Lower nominal wages will allow firms to lower prices. Though if prices fall as much as nominal wages, real wages will no, and we had stayed in same paragraph.
As with 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 illustrate long periods of high unemployment in classic model with the model of labor used there.
- During the Great Depression in early 1930s (the great depression), it became increasingly apparent that traditional model had flaws. Unemployment was very high for a long time and any adjustment to the balance of labor market wasn't.
- In Keynesian model, can the economy to be in balance even with a high level of involuntary unemployment and model appeared to be a good explanation for depression.
- I check the model, financial policy is a very significant role. By increasing G so, the government can increase GDP and hence reduce unemployment.
- The classic dichotomy between nominal and real variables will disappear in all Keynesian models.