Working Against Yourself

Proposed changes to the Employment Insurance (EI) scheme by the federal government go against sensible economic thinking. Reducing the unemployment rate by requiring people to take lower paying jobs, or work outside their chosen field, may actually decrease output and employment, rather than raising it, as the government hopes.

As Keynes argued in The General Theory, employment is determined by the aggregate demand for goods, which is in turn determined (in a closed economy) by consumption demand and investment demand. Consumption depends mainly on the level of real income while investment demand depends on the interest rate, which is determined by money supply and the demand for money, and by business expectations. Thus, it is demand which determines the level of employment, not wages.

The level of employment thus determined may be less than the full employment level at which the supply and demand for labor (which depend on the real wage) become equal. Keynes also examined the aggregate supply side of the economy with a given money wage, and a production function relating output to employment, which determined the average price level. He argued that the wages are likely to be rigid downward when unemployment exists because of workers’ concern with their wage relative to that of others. The key insight is that, even if wages (and hence the price level) fall, this is likely to decrease the level of aggregate demand due to lower incomes and the negative effect of falling prices on investment demand.

Putting downward pressure on wages, which seems to be the unspoken policy of the current government, is therefore likely to be counterproductive. If lower wages result in lower consumption, and hence demand, unemployment will rise, not fall.

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