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252 Unemployment and Monetary Policy in the European Union
The final outcome of the process is an “equilibrium” in which the money
market—as well as other markets with flexible prices—clear, but the labor market
may end up with an excess supply because there is not enough demand for output
to absorb the full-employment labor supply. But it will still be in Keynesian equilibrium,
for with wage rigidity, the excess supply will not cause wages to adjust
further. (In the case of an excess demand for labor, nominal wage rigidity could
only be transitory and eventually result in higher wages and prices, which would
reduce demand along the lines of the traditional model.)
The essence of the Keynesian Revolution is that the money market is cleared—
i.e. the demand for money is brought into equality with the Central Bank determined
money supply—not through an imaginary high flexibility of wages, but
through movements in unemployment and interest rates.
4.2 Nominal Wage Rigidity versus Real Money Supply
It has been argued that the market failure in this case reflects the rigidity of wages
and prices that do not respond to the excess supply. But when unemployment is
due to nominal wage rigidity, it is just as correct to conclude that it reflects a
shortage of real money supply. For if the equilibrium could be re-established by
an x percent decline in nominal wages, then to the extent that nominal wages are
truly rigid up to a neighborhood of full employment, equilibrium could equally
be re-established by an x percent expansion of the real money supply, whether
by a fall in prices of a rise in the nominal money supply, or and combination of
the two.
4.3 Nominal Wage Rigidity, A Source for Concern or an
Opportunity for Improved Stabilization?
The hypothesis that nominal wages were rigid, or very sluggish, was widely
accepted in the early postwar period. It was initially a source of concern
about economic stability. For clearly, the real money supply required for full
employment could be expected to vary over time as a result of parameter shifts
and other shocks. But with rigid prices, there was no mechanism to ensure
that the real money supply would tend to move toward the appropriate level;
hence the danger of significant discrepancies and corresponding movements in
unemployment.
However, there soon was a more fundamental shift to optimism as it was realized
that, if wages are prevailingly rigid, the real money supply could be readily
controlled by the simple operation of changing the nominal money stock to
accommodate demand. Hence the exhilarating feeling, lasting through the 1960s
and early 1970s, that the problem of unemployment had largely been brought
under control, and that there was an important task for the macroeconomist in