Wednesday, February 24, 2016

Frank Knight on unemployment equilibrium

Luca Fiorito, my sometimes co-author, and Carlo Cristiano have published (subscription required) class notes from Frank H. Knight's business cycle course in the fall of 1936, that used Keynes' General Theory (GT) as one of his references. Two quotes from the notes by Perham Nahal are reproduced below.
The main postulate of Keynes: the supply curve for labor should be drawn in terms of money, with no reference to the value of money (real vs. money wages). There is no tendency for the price of labor to adjust itself so as to clear the market.
It is not intelligent to take antithetical assumptions, as Keynes has done. There must be an enormous amount of inertia in an economic system to keep it from flying to pieces. Frictionless conditions are a fallacy. Because the classical assumptions did not work, they were not necessarily wrong. It is entirely possible that ‘frictions’ or undiscussed tendencies are responsible for deviations of actual conditions from what the classical economists believed would happen.
Unemployment is essentially the failure of the market to establish a clearance (FHK). Keynes seems to think that there is no such tendency toward clearance of the market. Keynes is wrong – this is FHK's criticism of Keynes. Keynes's talk of stable ‘equilibrium’ is ridiculous. How is this possible when there is unemployment? Competitive conditions tend to clear the market – if there is unemployment the ‘natural’ forces are working out too slowly, or there are obstacles. Any talk about stable equilibrium where the market is not cleared is nonsense. The fact that savings are sometimes not cleared does not invalidate a ‘law’ or tendency. If there were no tendency for prices to be set that would clear the market, there would be no system. [Emphasis added]
I do spend sometime with students emphasizing how important it is that Keynes suggested that the system was stuck in an unemployment equilibrium situation, and how contradictory that would be for neoclassical (classical for Keynes and Knight) theory.

Of course, while it seems clear that Knight dealt with chapter 3 of the GT, it seems evident from the class notes that he did not grapple with the issues in chapter 19, which explain how, even without frictions, without wage rigidities, the system remained below full employment.

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