Understanding interactions between labour and product markets is essential to the formulation of employment policies. When prices are more responsive than wages in Keynesian models, a rise in demand reduces real wages and raises employment; with sluggish prices, it raises the demand for labour directly. In neoclassical theories, a product demand shock may induce errors in price expectations or intertemporal substitution of labour and a temporary outward shift of the labour supply curve. In Discussion Paper No. 844, Assar Lindbeck and Programme Director Dennis Snower maintain that both approaches have severe deficiencies. Their channels of transmission via the real wage imply that its movements are countercyclical, but they are often acyclical or even procyclical in practice. They also tell us very little about the effects of changes in product demand on employment once wages and prices have responded fully or the effects of intertemporal substitution and errors in price expectations have worked themselves out. This is a serious handicap if demand variations are to account for employment fluctuations, since periods of high or low unemployment can last for several years.

Lindbeck and Snower identify channels transmitting product demand changes to employment which neither assume wage-price inertia nor imply countercyclical real wage movements. This should plausibly account for the effects of demand management policies and other demand changes on employment over the medium run (with capital roughly constant and diminishing returns to labour) and the long run (with full adjustment of the capital stock). They abandon the common assumption that any rise in product demand increases the demand for labour, which they show depends rather on whether a limited number of transmission channels are open. Supply-side channels operating through the degree of capital utilization, entry and exit of firms, and the productivity-enhancing effects of investment in infrastructure should strengthen demand-side policies' longer-term impact on employment. Public investment in infrastructure may have a greater impact on employment than either tax reductions or increases in transfer payments.

How are Product Demand Changes Transmitted to the Labour Market?
Assar Lindbeck and Dennis J Snower

Discussion Paper No. 844, September 1993 (HR)