The old debate between Keynesians and Monetarists is often considered to have been about the monetary transmission mechanism or the Phillips curve. However, an important element of the debate was in regards to unemployment and its effect on real output.
The typical Keynesian story about unemployment is that an increase in unemployment reduces income, which reduces consumption, and reduces aggregate output. Individuals base decisions on current income receipts. Unemployment benefits thus serve to compensate the job loser from the fall in income.
The monetarist view of unemployment, however, is framed within the context of Milton Friedman’s (1957) permanent income hypothesis. According to the PIH, permanent income is known, but there is uncertainty surrounding current receipts. A job loser whose behavior is characterized by the PIH will increase measured unemployment, but whether or not the job loss impacts real output depends on whether the change of circumstance results in a permanent downward revision of anticipated income. An increase in unemployment that is expected to only cause a change in receipts will not cause a reduction in consumption or real output.
Consider the implications of each theory. Suppose that the demand for labor falls. Employment and current income receipts decline. In the Keynesian theory, unemployment could be reduced if money wages were to decline. However, money wages are fixed by institutional datum. Unemployment compensation is necessary to prevent further reductions in real output because consumption is based on current income receipts.
In contrast, in the Monetarist theory, the reduction in employment and current receipts only affects output to the extent that anticipated income declines. If individuals fail to revise down expectations of permanent income, there is no effect on output. What’s more, money wages in the Monetarist theory remain sticky. However, unlike the Keynesian story, this is not the result of institutional datum. Rather, money wages are sticky because the supply of labor is a function of the real wage AND permanent income. Thus, unemployed workers only accept lower money wages if they revise down their estimates of anticipated future income. Unemployment compensation thus serves to smooth out receipts, but it does not affect consumption.
I bring up this distinction because much of the talk surrounding extensions to unemployment benefits has been framed in the context of the Keynesian theory or the labor-wedge-real-business-cycle-type theory. As a result, the debate has focused on the disincentive to work created by unemployment benefits. While I have little doubt that unemployment benefits and expansions thereof provide a disincentive to work, I am not convinced that this effect is large in magnitude.
In contrast, I think that looking at this debate in the context of the Keynesian v. Monetarist debate provides much more insight. According to the Keynesian theory, prolonged unemployment causes a reduction in income receipts and therefore a decline in aggregate demand and a reduction in real output. Increases in the duration of unemployment benefits thus serve to prevent (at least in part) the reduction in income receipts thereby preventing reductions in aggregate demand and real output. Meanwhile, the Monetarist theory suggests that extending unemployment benefits smooths current receipts, but has little effect on aggregate output.
This distinction between Keynesian and Monetarist theories is important as the former implies that increases in unemployment compensation have a stimulative effect on the economy. Meanwhile, the Monetarist theory suggests that such extensions will have little, if any, effect.
UPDATE: Blog friend Nick Rowe suggests in the comments that I am arguing that output does not fall at all in the Monetarist theory. I hope that is not the takeaway from this post. The decline in unemployment should be understood as the result of a real or nominal shock that pushes output below potential. The difference between the Keynesian and the Monetarist theories is whether consumption declines following the increase in unemployment and whether the extension of unemployment benefits is “stimulative”. For more, see my thoughts in the comments.