Managing Aggregate Supply and Aggregate Demand
Chapter 5 of Volume I lays out the conditions under which the market for labor clears: Firms hire labor up to the point where the marginal product of labor equals the real wage rate. Workers, in turn, expand their provision of labor until the marginal rate of substitution of leisure for labor income equals the after-tax real wage rate. This brings about an outcome called “full employment.” Corresponding to this state is full-employment GDP or potential GDP.
We can take full employment to be a condition in which the number of job openings just equals the number of workers who want jobs. This does not mean that everyone who wants to work has a job. Unemployment will never be zero. There will always be some openings that temporarily go unfilled and therefore some workers who temporarily go jobless. One type of unemployment is “frictional unemployment,” that is, unemployment that exists because some workers are between jobs or because they just entered the labor force and are searching for a job that meets their expectations. Another, more problematical, type of unemployment is “structural unemployment,” that is, unemployment that exists because unemployed workers’ skills do not match the requirements of the jobs that are open.
The best way to characterize unemployment that exists when there is “full employment” is to contrast it with unemployment that is attributable to imbalance between aggregate demand and aggregate supply of labor. In the Keynesian model such unemployment is called “involuntary,” in the sense that workers want to take jobs but can’t induce employers to open up job opportunities at any wage at which they might be willing to work. In the “suppressed inflation” model, which is about to be considered, the problem will be that employers can’t get workers to take a job at any wage they might offer.
In the “classical” model, the market for labor automatically clears through real-wage adjustments in the event of temporary imbalances between supply and demand. If the real wage rises above the equilibrium level, the resulting excess supply of labor will cause it to fall until equilibrium is restored. If it falls below the equilibrium level, the resulting excess demand for labor will cause it to rise again until equilibrium is restored.
Keynes wanted to revise economics to account for the fact that the economy could fall into a non-self-correcting state of low employment. Keynes was right about one thing concerning the Great Depression, which was the worst period of low employment in U.S. history: Real wage adjustments of the kind needed to restore “full employment” either did not occur or were not working, and the result was a long-lasting state of affairs in which there was an excess supply of both goods and labor.
There is a question of what to call such a state of affairs. It could be seen as a disequilibrium, since it is characterized by an imbalance between supply and demand. Here it will be considered an “equilibrium,” though certainly one not to be wished for. During the Great Depression and until World War II, the United States suffered a long period of low employment.
A low-employment “equilibrium” is therefore an economic state that is not self-correcting. The long-run/short-run dichotomy is meant to recognize a distinction between an equilibrium in which aggregate supply equals aggregate demand and an equilibrium in which it does not. Keynes taught a generation of economists to believe that a low-employment equilibrium would always be one in which there was excess supply: The aggregate supply of labor would exceed the aggregate demand for labor, and the aggregate supply of goods would exceed the aggregate demand for goods.
One purpose of this chapter is to show that a low-employment equilibrium can just as well be characterized by excess demand. In this short-run equilibrium, the aggregate demand for labor exceeds the aggregate supply of labor, and the aggregate demand for goods exceeds the aggregate supply of goods.
As mentioned earlier, the name ordinarily given to this rarely considered condition is suppressed inflation, usually associated with episodes in which countries impose price controls or “forced savings” measures on their citizens. In this chapter, we will see how this condition would arise from a failure of nominal wages and prices to rise in tandem with an increase in aggregate demand, that is, from upward stickiness of nominal wages and prices.
Keynesian unemployment occurs when there is a downward “stickiness” of nominal wages and prices, which in turn creates an excess supply of labor and goods. Conversely, suppressed inflation occurs when there is an upward stickiness of nominal wages and prices, which in turn creates an excess demand for labor and goods.
Either condition creates a case for government intervention in the form of discretionary monetary or fiscal policy. It is just that, of the two, the first is by far the most familiar, as the scenario that became the most recognized interpretation of Keynes’s General Theory. Also the two conditions call for opposite responses from government. Keynesian unemployment calls for expansive monetary and fiscal policy. Suppressed inflation calls for contractive monetary and fiscal policy.
Aggregate Supply and Demand in the Classical Model
In the classical model, in which the aggregate supply of labor equals the aggregate demand for labor, there are exactly as many employment opportunities as there are age-eligible people who want to be employed. (More specifically, the number of hours of labor time that employers want to fill with workers is exactly equal to the number of hours of labor time that age-eligible people want to supply.) As pointed out previously, it is important not to infer that, in the classical case, every hour of time offered by workers is in fact filled with an hour of employment or that every hour of time demanded by employers is filled with an hour of work. Mismatches between supply and demand can still occur because of “frictional” or “structural” imbalances. But the number of work opportunities just matches the number of work hours available to fill those opportunities.
The analysis begins with the assumption that people hold their wealth in the form of cash. Recall Table 1.1 in Chapter 1 of this volume where cash balances M started out at $1,000,000 and then rose, first by 5% a year and then by 6%. Let’s assume that there is $1 million in circulation and that P = 1. Then the real money supply is
Now we need a few assumptions about labor and goods. To make life as easy as possible, let’s assume that there is one good, pizza, which sells for $1 a slice. Let’s also assume that workers receive a nominal wage of $10 per hour. Finally, let’s set the price level P equal to the price of a slice of pizza.
The worker’s real wage w is his nominal wage W divided by P:
In other words, the worker is rewarded the equivalent of 10 slices of pizza for every hour of work.
Now what happens to that $1 million that people have in their pockets? Well, they use it to buy pizza. How much do they spend? That depends on the velocity of money. Suppose that the velocity V is 2, which implies that the average dollar turns over twice in a year. Thus, nominal income equals
which means that people buy $2,000,000 worth of pizza slices and make $2,000,000 producing them. This is the same y that we called nominal GDP in Chapter 2.
Real income equals
which reflects the fact that people produce and buy 2,000,000 pizza slices a year. We can recast these numbers in terms of the “quantity theory” equation:
or, in the example,
So far, all we have is a string of identities illustrated with hypothetical values of the variables involved.
Now we can introduce theoretical content by writing down the equation seen earlier:
where k is the inverse of the velocity of money and assumed to be constant. As pointed out, we can think of the left hand-side of (3.7) as representing the supply of nominal cash balances and the right-hand side as representing the demand for nominal cash balances. Rewriting (3.6) to conform to this format, we get
The left-hand side of this equation tells us that people have $1,000,000 in cash at their disposal. The right-hand side says that people want to hold exactly that much in cash. Supply equals demand.
Now suppose that the government reduces the money supply by 50% from $1 million to $500,000. If the left-hand side of (3.7) falls by 50%, so must the right-hand side. If k is constant, then P and Y must adjust in such a way as to restore balance between supply and demand. For the time being, before the right-hand side adjusts, assume that the supply of nominal cash balances is less than the demand for nominal cash balances:
Because consumers find themselves with only half as much in nominal balances as they did before, they try to rebuild those balances in order to bring their money holdings, on the left-hand side of the equation, back into line with their demand for money holdings, on the right-hand side of the equation. But because the only way that they can accomplish this is by spending less on goods supplied by each other, something has to give on the right-hand side. Assuming that k is constant, that “something” must be a fall in P, a fall in Y, or some combination of the two. In the classical case, the adjustment consists entirely of a fall in P. As M falls by 50%, P falls by 50% and balance between the two sides is restored.
The nominal wage rate must also fall, however. Because P has fallen by 50%, the real wage would double if the nominal wage did not also fall by 50%. There is no logical reason why workers would not accept the required cut in their nominal wages. If fully informed, workers would understand that if they were unwilling to accept this wage cut, employers would be compelled to reduce the amount of labor time employed. They would also understand that, with the price of a slice of pizza now at $0.50, they could accept a 50% decrease in their nominal wage and still be paid, in effect, 10 slices of pizza per hour of work.
In the classical case, therefore, a change in M brings about a proportionate change in P and W in the same direction and leaves the real wage rate and real output unchanged. We can encapsulate some of this information in a single graph by thinking of the left-hand side of equation (3.5) as the level of aggregate demand (AD). See Figure 3.1. The AD curve represents aggregate demand and the LRAS curve long-run aggregate supply.
If MV rises, aggregate demand rises. If MV falls, aggregate demand falls. For a given level of MV, then, the AD curve shows the different combinations of P and Y that will satisfy equation (3.5). The aggregate demand curve then becomes a rectangular hyperbola, in that the product of the vertical axis variable and the horizontal axis variable is always the same and equal to MV. Here, the LRAS supply curve is vertical to indicate that that level of output is constant for any level of aggregate demand.
Figure 3.1 Long-run equilibrium price and output
To see how it works, let a rise in M bring about a rise in aggregate demand, from AD1 to AD2 in Figure 3.2. The AD curve shifts up and P rises in proportion to M, from OB to OC. There is no change in Y if
M alone rises and V remains constant. Temporarily,
Because k and Y are constant, P must rise in proportion to M. The economy moves from point X to point W. This is the process illustrated in Chapter 1, Table 1.1, of this volume.
Alternatively, if M falls, and with it AD, temporarily:
P falls in proportion to M from OB to OD, and the economy shifts from point X to point Z as the aggregate demand curve shifts down the LRAS curve from AD1 to AD3.
The reality is that the seamless adjustments to changes in M assumed in the classical model are in fact just simplifying assumptions that work well for considerations of the long run but seldom apply in the short run. The fact that information about observed changes in demand is often imperfect means that there can be maladjustments to these changes. The question, then, is whether those maladjustments are short-lived or protracted. It is to this question that we turn next.
Figure 3.2 Shifts in AD along the LRAS curve
Short-Lived, Self-Correcting Maladjustments: Worker Myopia
For output to be independent of the level of aggregate demand, both prices and wages must adjust instantaneously in proportion to changes in AD. But what if prices and/or wages do not adjust in this way? What sort of maladjustments might occur and what processes will work toward their correction?
Macroeconomists use the expression money illusion to connote a blind refusal by workers to recognize that what matters is their real wage, not their nominal wage. If workers suffer from this kind of myopia, they will refuse to take wage cuts in the face of falling prices, even if they know that by refusing to do so, they will cause the cost of labor to rise and force their employers into resorting to layoffs. Likewise, they will hesitate to demand wage increases in the face of rising prices, even if they know that by failing to do so, they may end up working longer hours for a lower real wage.
It is possible to consider the problem of price and/or wage rigidity, however, without assuming unwillingness on the part of workers to realize that their real wages are what matter. Assume the existence of multiple pizza shops selling different brands of pizza. As before, the government reduces the money supply and pizza consumers cut back on their purchases unless and until store owners cut their prices. In this process, suppose the local Domino’s franchise tells its workers that they have to accept 50% wage cuts but not to worry since the general price level is also falling by 50%. They will continue to get their ten pizza slices per hour of work in compensation if they are willing to accept the wage cuts. The workers are, however, skeptical. They have heard rumors that Pizza Hut has improved its product and that the reason Domino’s is losing customers is due to competition from Pizza Hut. They conclude that there is no change in monetary policy, but rather an increase in competition from Pizza Hut. The falloff in demand for Domino’s pizzas could be a localized shift in consumer demand from Domino’s to Pizza Hut. Workers see only what is in front of them, not the broader picture.
Meanwhile, Pizza Hut workers arrive at a similar conclusion when they are told that they have to accept a wage cut. They likewise refuse to go along with this wage cut, suggesting that this attitude is uniform for all pizza workers. Each worker reasons that he would rather see what other workers do before he takes it on faith that all he has to do is accept a lower wage in order to keep his job, and at the same time make the same real wage as before. This general refusal to take nominal wage cuts is not based on a failure of workers to understand that it is their real wages that matter, but rather a misperception about the underlying cause of a falloff in demand for whatever product their employer is selling. The result is that when aggregate demand falls, so does Y.
In Figure 3.3, the downward shift in AD moves the economy from point X to point W along the short-run aggregate supply curve 1 (SRAS1). Prices fall from OB to OC, but wages do not fall in proportion. This leads to a reduction in quantity of labor supplied and a reduction in output from OA to OE, along SRAS1. Prices do not fall in proportion to the fall in M since the fall in Y in and of itself reduces the demand for money. Yet, the percentage fall in prices exceeds the percentage fall in nominal wages for reasons explained. The result is that the cost of labor, equal to W/P, rises, and employers eliminate some workers and in the process, reduce output.
The reduction in output can end up being a short-lived phenomenon. All that is needed is for the Domino’s and Pizza Hut workers to realize that their refusal to accept wage cuts was based on a misunderstanding about why their employers’ business was falling off. Once workers understand what really happened, they will accept the necessary nominal wage cuts. With workers accepting wage cuts, short-run supply will rise, which implies it will shift from SRAS1 to SRAS2, which intersects the LRAS curve at Z. Output will return to OA, where, as before, AD equals LRAS, and prices will fall to OD.
Figure 3.3 Decrease in AD and increase in SRAS with worker myopia
There can be misperceptions also about the cause of a rise in demand. Suppose the monetary authorities increase M, which causes aggregate demand to rise. Pizza buyers will line up in front of pizza shops demanding more pizza, and pizza sellers will ask their workers to put in longer hours to accommodate the rise in demand.
Because consumers find themselves with increased nominal cash balances, they try to spend those balances in order to bring their holdings of nominal balances, on the left-hand side of (3.10), back into line with their demand for nominal balances, on the right-hand side of (3.10). But because the only way they can accomplish this is by spending more on goods supplied by each other, something has to give.
Given that k is constant, that “something” must cause a rise in P, a rise in Y, or some combination of the two. In the classical case, the adjustment consists of a rise in P and a proportionate rise in W. If M rises by 50%, and P and W rise by 50%, the balance between the supply of money and the demand for money is restored.
Suppose, however, that W does not rise in proportion to P. Because P has risen by 50%, the real wage would be cut by 1/3 if the nominal wage did not also rise by 50%. With pizza now priced at $1.50 per slice, workers should be unwilling to work at current levels unless their nominal wage rate rose by enough (from $10 to $15 per hour) so that they continued to earn a real wage of ten pizza slices per hour. Employers, for their part, should be willing to offer this pay increase since they can also raise their prices by 50%. Production should remain unchanged.
Suppose, however, that Domino’s workers are reluctant to demand a 50% wage increase since they believe that the increase in demand for Domino’s pizzas reflects a shift in consumer demand from other pizza brands to Domino’s. If these workers think that the rise in the price of Domino’s pizza is limited to that brand, then they might perceive a less-than-50% wage increase as a rise in their real wage. They might also then be willing to put in more hours of work, with the result that Domino’s would produce more pizza. Given that all pizza employers experience this reluctance on the part of their workers to demand higher wages, production will rise.
Figure 3.4 Increase in AD and decrease in SRAS with worker myopia
Now consider Figure 3.4. The rise in AD causes the economy to move out along SRAS1, from point X to point W, with the result that Y expands from OA to OE and prices rise from OB to OC. Output expands because workers provide more of their services on the false assumption that the nominal wage increases being offered to them are high enough, relative to the rise in P to permit their real wages to rise. Prices rise but their rise is mitigated by the fact that the demand for money rises with the rise in Y. Again, wages are stickier than prices, with the result that real wages fall.
This state of affairs may last only briefly, however. Once the workers realize that their nominal wages have risen less than in proportion to P, they pull back on their services. The short-run average supply curve shifts from SRAS1 to SRAS2. As Y falls back to OA, prices rise to OD, and the economy now adjusts to point Z.
Short-Lived, Self-Correcting Maladjustments: Employer Myopia
Now let’s consider the consequences for the economy of employer myopia, as it can surface after a change in aggregate demand. Suppose again that the money supply rises and this time suppose that employers are reluctant to raise wages in proportion to prices. Perhaps the Domino’s manager wrongly believes that the increase in demand for his pizzas has resulted from the success of the Domino’s chain in its efforts to market a better pizza. The manager might not think it necessary to pay his workers more since what he is observing is not a general increase in the demand for pizza but a localized shift from his competitors’ stores to his.
But then the Pizza Hut manager, acting on the same unfounded supposition, also refuses to raise nominal wages, as do all the other store managers, with the result that workers, facing a reduction in their real wage in the face of an expected general rise in the price of pizza, decide to withhold their services. This in turn causes store managers to cut back on production, which reduces the supply of pizza.
Figure 3.5 provides an illustration. The rise in demand moves the economy from point X to point W on SRAS1. Prices rise from OB to OC and output falls from OA to OE, the reason being that employers refuse to offer wage increases in proportion to the rise in prices. The rise in prices is more than proportionate to the rise in M since output falls. Again, wages are stickier than prices but this time it’s because of an unwillingness on the part of employers to match the rise in prices with higher wages. The consequent unwillingness of workers to put in as many hours as they did before causes output to fall.
Figure 3.5 Increase in AD and increase in SRAS with employer myopia
This scenario resembles what is called “repressed” (or suppressed) inflation in the macroeconomics literature. “One of the most striking characteristics of repressed inflation is that the demand for labor at the price paid for labor is always greater than the supply, since that price [paid for labor] is below equilibrium”1 (Charlesworth 1956, p. 26).
In the modern economy, there are few price controls (except, notably, for the health care sector), but limitations on the wage incentives to supply labor are entirely possible. Suppose that there is a government-engineered increase in aggregate demand that takes place simultaneously with a government-engineered increase in taxes on goods, wages and capital income. Aggregate demand would rise, and the supply of goods and labor would fall, inducing people to allocate their increased disposable income to saving.
In the pizza example, the underemployment brought about by repressed wages will be short-lived, however, if employers quickly realize their mistake and offer wage increases commensurate with the rise in prices. As employers offer higher wages, short-run aggregate supply will shift to the right from SRAS1 to SRAS2 in Figure 3.5. In response to the rise in output, prices will fall from OC to OD, equilibrium will shift to point Z, and output will return to its long-run, full-employment level OA.
We would get the reverse of this case if aggregate demand fell and if employers were reluctant, for parallel reasons, to reduce the wages they pay, in line with falling prices. Perhaps the employer believes that the fall in demand is localized to his own pizza brand and he cannot expect his employees to take wage cuts as demand falls off. This turn of events is illustrated in Figure 3.6. Aggregate demand falls, shifting the economy from point X to point W along SRAS1. Prices fall from OB to OC. Even though aggregate demand has fallen, the reluctance of employers to cut wages in tandem with falling prices causes workers to offer more of their services and causes output to rise temporarily from OA to OE.
Figure 3.6 Decrease in AD and decrease in SRAS with employer myopia
Once employers realize that their reluctance to cut wages is unwarranted, they will cut wages in tandem with the fall in prices. Short-run aggregate supply will shift from SRAS1 to SRAS2, prices will rise to OD and output will return to its long-run equilibrium level as the economy adjusts to point Z.
In this section and the one before, the general presumption in favor of relative wage “stickiness” was brought about by worker or employer myopia. In both the sections, wages lag behind prices until either workers or employers are able to see their error and make the needed correction. The logic here flows from the fact that when people find themselves holding more money (or less money), than they wish to hold, they will collectively attempt to bring their actual moneyholding in line with their desired moneyholding, the effect of which is to cause aggregate demand to rise (or fall).
Whether that leads to a temporary rise (or fall) in output depends on the ability of workers and employers to see what is afoot: That there is an economywide rise—or fall—in aggregate demand. Workers and employers must then diagnose what the change in demand means to their particular part of the economy. It is the possible lag between when workers and employers feel the impact of the change in aggregate demand and when they determine that the impact was in fact attributable to a change in aggregate demand that causes the maladjustment.
The maladjustments considered in the prior two sections were shown to be self-correcting. Let’s now identify the appropriate policy responses to Keynesian unemployment and repressed-inflation unemployment, when those conditions are not self-correcting.
Protracted Maladjustments: Keynesian Scenario
In the prior two sections we saw two scenarios in which output could fall below the full-employment level. In the first, aggregate demand fell, and workers refused to accept wage cuts commensurate with falling prices. In the second, aggregate demand rose, and employers refused to offer wage hikes commensurate with rising prices. In both instances we saw how corrective shifts in short-run aggregate supply could move the economy back to full employment without government intervention. Here we consider how a fall in output owing to wage and price rigidities could lead to a protracted period of economic underperformance.
Let’s return to the case of worker myopia. Figure 3.3 illustrates the effects of an unwillingness by workers to take wage cuts. At first, this wage rigidity causes output to fall as the reduction in M causes aggregate demand to fall. Then, however, as workers discover their mistake and signal their readiness to take wage cuts, short-run aggregate supply rises until output returns to its full-employment level.
Consider, however, the possibility that as workers take time to figure out their mistake and signal their readiness to take wage cuts, aggregate demand will fall yet again owing to the layoffs that the original reduction in aggregate demand brought about. Employers, having laid off some of their workers, experience an additional fall in demand owing to the fact that the laid-off workers have no income to buy their goods.
Now let’s add another factor. The fall in M necessitates wage cuts, but it necessitates price cuts as well. We saw that in the example, noted earlier, of a 50% reduction in M, which, when combined with a 50% reduction in P and W, leaves output unchanged. It would not be enough only for workers to accept nominal wage cuts, but employers must also cut their prices, so that pizza sales remain unchanged in the face of lower money balances. That is, both P and W must fall. If they do not fall in tandem, employers will have to lay off at least some of their workers.
And that would not be the end of it. If there is no proportionate cut in P and W, individual employers will experience a loss of business, not just because their prices are too high but also because other employers have laid off workers, whose demand for consumer goods falls. There is the first reduction in aggregate demand resulting from wage and price rigidity but then also a second reduction owing to the layoffs that result from the first round of layoffs.
This next reduction in aggregate demand will bring about yet another reduction in the work force, and then yet another, and so forth until the resulting shrinkage in output reaches some limit. This is the Keynesian multiplier at work. This is also what we might call a depression scenario—an economic downturn of unusual length and severity.
It is important, incidentally, to realize that worker myopia need not be the only factor leading to this result. Minimum wage laws make it difficult for employers to cut nominal wages, as do labor contracts. Unions often seem more willing to let employers lay off workers than to accept wage cuts.
What distinguishes this scenario from the one illustrated in Figure 3.3 is that the needed wage cuts take too long to head off a multiple round of job cuts, for which no automatic correction remains possible. The Keynesian solution: Expansive fiscal and/or monetary policy.
To see how this remedy works, let’s write down the expenditure-approach formula for GDP:
where C is consumption, I is gross private domestic investment, G is government purchases and NX is net exports. Where Keynesian low employment prevails, supply exceeds demand, which means that goods are going unsold, factories are operating below capacity and workers cannot find jobs. In this state of affairs, the demand side of the market determines how much will be produced, the degree to which production capacity will be utilized and the number of workers who will be hired (more exactly, the amount of labor time that will be used).
With Keynesian unemployment, consumers are unable to convert their labor time into goods. Factory owners are unable to convert their production into sales and are thus unwilling to invest in new capacity or even to maintain existing capacity. Store owners cannot convert their inventories into sales. Gross private domestic investment is low and net private domestic investment may be negative, as the existing capacity is allowed to depreciate. Consumers are constrained from buying goods due to lack of demand for their labor services. Factory owners are constrained from buying capital goods, and store owners are constrained from building inventories by virtue of the lack of demand for their goods.
In this state of affairs, the assumptions of the classical model no longer apply. In particular, people can no longer decide how to allocate their time between work and leisure and their current income between consumption and saving on the assumption that they can provide as much of their labor services as they choose to employers at the current wage rate. Because people are constrained to provide fewer such services than they would wish, they are left in a state of affairs in which the reward for giving up another hour of leisure, that is, the real wage rate, is greater than the amount of labor income with which they would have to be compensated in order willingly to give up that hour of leisure:
The reason why the worker doesn’t sacrifice leisure and expand work is because work is not to be found. This leaves him with less disposable income than he would have had in classical equilibrium and, with less income at his disposal, he is less willing to consume.
In an earlier discussion, we saw that a temporary decrease in income would lead to only a small decrease in consumption and that, conversely, a temporary increase in income would lead to only a small increase in consumption. Here things are different: The worker has less labor income and therefore enjoys less consumption than he would prefer and, as a result, any increase of disposable income would have a substantial effect on his consumption, which in turn would provide a needed “injection” into the economy.
In the same earlier discussion, we saw that people make saving decisions according to the utility that they attach to current and future consumption and their preference for current utility over future utility. Saving is the willful postponement of consumption to the future, and, as such, frees up resources to be allocated to investment. In the Keynesian model, saving reduces the size of the injection brought about by an increase in disposable income, however, that increase is brought about. Saving (and imports) create a “leakage” out of the economic system that reduces the simulative effect of an increase in income.
In this analysis, with labor in excess supply, consumption depends on the quantity of labor that gets hired:
and the quantity of labor that gets hired is the quantity demanded, which depends on disposable income:
A second behavioral relationship is between investment and the real interest rate. Keynes saw investment as a function of the real interest rate:
where a fall in r brings about a rise in I. The representation of the demand for investment as a function of the real interest rate is another departure from the classical model, in which the demand for capital is a function of the real interest rate. In the Keynesian system, the ability of the monetary authorities to reduce the real interest rate provides a portal through which government can inject new demand into the economic system through increased investment.
It is necessary to recognize how government deficits can lead to a rise in r and therefore fall in I. This is what Alan Blinder’s comments, quoted in Chapter 1, were about. But this would not be, as he argued, a long-run phenomenon, but rather a short-run, Keynesian phenomenon. In the long run, it is not deficits but unexpected increases in government spending that can lead to the crowding out of investment, as explained the Chapter 8 of Volume I.
The ability to expand Y rests on the opportunity that the monetary authorities have in a time of low-employment equilibrium to push down the nominal interest rate R through monetary expansion. Return to the Cambridge equation,
In the classical model and under full employment, an increase M will bring not about an increase in Y. But suppose that PY (nominal GDP) does not rise in tandem with M. Temporarily, again,
Something has to give, but what will it be?
The answer is that k must rise, which implies that velocity must fall. The mechanism needed to get velocity to fall is through a decrease in the nominal interest rate, which will cause the demand for money to rise, bringing the right-hand side of (3.18) into line with the left-hand side. We can construct a demand function for money that provides the necessary linkage between an expansion in M and a fall in R. This is the scenario illustrated in Table 1.3 of Chapter 1 of this volume.
Monetary policy can also affect net exports through changes brought about in the real interest rate and in the exchange rate. Under flexible exchange rates, an increase in the money supply will have a limited effect on I, insofar as any departure of the home-country interest rate from the global interest rate will be self-correcting. When the monetary authorities push down the interest rate by expanding M, capital flows out of the home country into other countries, which means NFI rises. As investors move funds from dollars into other currencies, the dollar depreciates. The resulting rise in 
will cause exports to rise and imports to fall. We can then write an equation for net exports NX, expressed as a function of :
Now returning to equation (3.12) and recognizing that production is determined on the demand side of the market, we can write
We see that there is a behavioral relationship between CD and LD and between LD and Y – T. When we combine these relationships into a single expression we get
The change in CD that results from another dollar of disposable income equals the change in CD, which results from the provision of an additional unit of labor multiplied by the change in the amount of labor demanded per dollar change in disposable income.
The coefficient b is what Keynes called the marginal propensity to consume or MPC. Frequently, economists specify equation (3.20) as
Suppose the government wants to engineer a certain change in YD in order to move production closer to its full-employment level. Then it can use the equation
to determine the desired combination of monetary and fiscal policy for achieving the desired change in Y. The expression 1/(1 − b) is the Keynesian demand multiplier, which tells us how much Y will change for every dollar change in the bracketed term on the right-hand side of equation (3.24). We can think of the bracketed items as representing the policy instruments available to government for manipulating aggregate demand. The government can bring about changes in Y through its ability to control T, G, r, and . Changes in these variables bring about changes in Y through the Keynesian multiplier.2
A couple of examples will be helpful. Let’s assume that the MPC = 0.5 and that the government decides to buy $1 million more worth of Patriot missiles from the Raytheon Corporation in Massachusetts. That creates another $1 million in output right off the bat. This purchase by government requires Raytheon to hire additional labor for which it pays the $1 million, which in turn leads to the expenditure of 50% of that amount on goods by the newly hired workers. Given that the MPC = 0.5, these workers spend $0.5 million at local businesses for food, furniture, and other items. That adds another $0.5 million to output. Local stores have to hire additional labor to provide those goods, and the providers of that labor in turn spend $0.25 million (= 0.5 × $0.5 million) on goods, adding another $0.25 million to output. And so forth. The entire process can be laid out as follows:
Voila! By spending an additional $1 million, the government creates $2 million in new output and with it the new jobs that became needed in order to make this new output possible.
Equation (3.25) provides the long way of calculating the effect on output. The shorter way is to take advantage of the formula presented in equation (3.24) to get
There are other policy instruments available to government. An alternative strategy would be to cut taxes, thus “putting money in people’s pockets.” Now suppose that, instead of purchasing goods or services, the government cuts taxes by $1 million or, equivalently, sends out checks to individuals for this amount.
A tax cut of $1 million does not immediately “inject” $1 million into the economy. The reason is that taxpayers save 50% of that amount. They spend only the remaining 50%. But, again, we are not finished, because there are the same unemployed workers who will be put to work as taxpayers spend that 50% of their tax cut. And so forth. The process can be laid out as follows (keeping in mind that a tax cut means that the change in taxes dT is negative):
The short-cut solution is
This illustrates the use of the policy instruments available to the fiscal authorities. For the monetary authorities, in the Keynesian system, the trick is to take advantage of the stickiness of prices and the opportunity that presents to increase investment and net exports through expansive monetary policy. A change dr in the real interest rate through monetary expansion leads to an increase in investment. Suppose r is reduced from 3% to 1%. If investment rises by $100 for every percentage point fall in r (that is, if 
= $100), then the reduction in r brings about a $200 rise in investment, and through the multiplier, a $400 rise in output.
It is necessary also, in analyzing the role of r in this process, to consider how an expansion in the economy brought about by a rise in G or a cut in T can itself influence r. Recall that the demand for money depends not only on the interest rate but also the level of real income. If the government uses fiscal policy successfully to expand Y, the demand for money will rise. Because, under these assumptions, as the supply of money remains fixed, something has to rise in order to bring the demand for money back in line with the existing supply of money. That something is the interest rate. The interest rate will be under pressure to rise as Y expands, and a rise in the interest rate will cause investment to fall, thus dampening the positive effect of an expansive fiscal policy on output.
Given the sensitivity of international capital flows to variations in the interest rate, the effectiveness of fiscal policy might be quite limited. An upward push on the home-country interest rate will cause capital to flow into the home country and put pressure on the dollar to appreciate (i.e., for to fall). This will in turn cause NXD to fall and, with it, Y, bringing the demand for money back into line with the supply of money.
Figure 3.7 Increase in government spending: Keynesian case
Also important are the channels through which monetary policy works. In a closed economy, reduction in r, orchestrated through a rise in M, will cause investment and therefore output to rise. In an open economy, however, a reduction in r can be only temporary since it will spur an outflow of capital. Then, as mentioned, it is this outflow of capital that causes output to rise as the home currency depreciates and exports rise.
Now let’s illustrate graphically how government can use fiscal policy in a closed economy to expand Y and L.3 See Figure 3.7, where the failure of the wage rate to adjust to a downward shift in aggregate demand has resulted in a quasi-permanent below-full-employment equilibrium at point X. The LD and Y curves show the different combinations of labor and income that satisfy equations (3.15) and (3.20), respectively, with the economy resting at point X on curves LD and Y. We imagine that G takes one value along curve Y1 and a higher value along curve Y2. The LD curve shows the different quantities of labor that firms will demand for given levels of output that they can sell. The Y curves show the different amounts of goods that firms can sell for different amounts of labor that are employed.
At point X, OA workers have found jobs and firms have been able to find buyers for OB units of production. Point X represents an equilibrium, insofar as OB represents just enough in product sales to make it necessary to employ OA units of labor, and OA represents just enough employment to find buyers for OB units of output. But, we assume, point X also represents a below-full-employment equilibrium. If OA′ represents full-employment output, there is a case for government to intervene by increasing purchases by XZ (= dG). This causes the Y curve to shift up by XZ, so that the economy now finds itself on Y2 and at a new equilibrium W. Employment increases to OA′ and production to OB′.
Note that in an open economy and under flexible exchange rates, this process is likely to reverse itself as the rise in G and consequent rise in Y cause the demand for money and interest rates to rise. The resulting appreciation of the dollar will cause the YD curve to shift downward, causing Y to fall back to OB and L to fall back to OA.4
On the other hand, the government could bring about a permanent rise in production and employment through expansive monetary policy. The rise in M puts downward pressure on r and thus increases NFI until the resulting depreciation of the dollar causes net exports to rise and r to return to its previous level. Monetary policy is more effective than fiscal policy for bringing about an expansion of output under integrated global financial markets and flexible exchange rates.
Protracted Maladjustments: Suppressed Inflation Scenario
Now let’s turn to a scenario in which aggregate demand for goods and labor exceeds aggregate supply. This could occur because of employer myopia, as discussed previously, where employers refuse to provide wage hikes in the face of rising prices, and employees, as a result, withdraw from the labor force. It could also occur because government price controls prevent firms from raising prices, thus causing them to reduce production. In this version of excess demand, workers withdraw from the labor force, not only because of employer myopia but also because of the price rigidities that block increases in prices. The usual example involves the expansion of government in wartime and the price controls that government typically imposes in response to the inflationary pressures that, as a result, arise (Charlesworth 1956).
Let’s explore a case brought about by monetary expansion. If M rises by 50%, then W and P must also rise by 50%. P must rise in order to ration out the supply goods among buyers who now have larger cash balances and W must rise to prevent the worker’s real wage from falling. If both do not rise in tandem, the economy falls into a low-employment equilibrium parallel to the low-employment equilibrium experienced in the Keynesian case, the difference being that here the supply of goods and labor falls. Government can address this problem by instituting policies aimed at contracting aggregate demand.
The conditions described here are the opposite of the Keynesian case. In the Keynesian case, an expansive monetary or fiscal policy is aimed at pulling aggregate demand up into line with aggregate supply. In the suppressed inflation case, a contractive monetary or fiscal policy is aimed pulling aggregate supply up into line with aggregate demand.
In the Keynesian case, an expansion of G, I, or NX causes the demand for goods and labor to rise, thus causing the excess supply of goods and labor to fall. But here the problem is excess demand, not excess supply. Every dollar of production that goes toward the production of capital goods, government goods, and net exports is a dollar less that goes toward the production of consumer goods. We can write
whereby the quantity of consumer goods supplied equals production of all goods minus the production of capital goods, government goods, and net exports. Also, the amount of labor used in production equals the amount of labor supplied by workers, which is a function of the consumer goods available for them to buy and the taxes they have to pay.
Labor supply varies positively with C and T. It varies positively with C because a greater abundance of consumer goods makes it more worthwhile for workers to sacrifice leisure for labor income. It varies positively with T because higher taxes make workers feel poorer and thus more inclined to work.
Here we assume that taxes take the form of lump-sum taxes—taxes that the individual must pay irrespective of his work–leisure and his consumption–saving choices. In effect the government sends the individual a bill, which when paid, leaves him free of any additional tax liability. In short, the tax is imposed in such a way as to have only an income effect—to make the individual feel poorer and therefore to induce him to contract leisure and expand work. Not that this is a reasonable policy option. The analysis, however, does make it clear that in an excess demand scenario, the idea of “putting money in people’s pockets” is just the opposite of what is needed.
In this analysis, production depends on how much labor workers are willing to supply:
Substituting equation (3.30) into equation (3.31), we get
Production depends on the quantity of labor supplied, which, in turn, depends on the quantity of consumption goods supplied and taxes, both of which affect the quantity of labor supplied positively.
Now substitute equation (3.29) into equation (3.32) to get
We see that a decrease in I, G, and NX leads to an increase in the production of consumer goods, which leads to an increase in the supply of labor, which then leads to an increase in production. We can specify these relationships as follows:
Let
which equals the change in the supply of production per unit change in the supply of labor,
which equals the change in the supply of labor per unit change in consumption, and
which equals the change in labor supply per unit change in taxes. Then we can combine these parameters to get
which equals the change in the supply of goods per unit change in consumption, and
which equals the change in the supply of goods per unit change in taxes.
Now suppose that government decides to increase output by reducing spending (keeping in mind that dG is assumed to be negative) and/or increasing taxes. Then
We can give the coefficient f its own name. Let’s call it the marginal propensity to produce (MPP), by which we mean the increase in production that will take place because workers get another dollar of consumption goods.
Production will rise by 
for every dollar that government purchases are reduced. We can think of the coefficient as the output supply multiplier that applies to decreases in aggregate demand. Similarly, production will rise by 
for every dollar that tax burdens are increased.
Suppose that the MPP equals 0.9. Then a $1 million reduction in government spending will lead to an increase of $9 million in production. First, the $1 million in reduced government purchases frees up resources that flow into the production of consumer goods, permitting consumers to buy $1 million more in goods. So far, there is no effect on production: The government has, by its action, simply caused producers to replace $1 million of government goods with $1 million of consumer goods. Now, however, consumers, seeing $1 million in new consumer goods on store shelves, provide more labor time to employers, enough to induce the production of an additional $0.9 million in goods, which in turn, causes consumers to provide more labor time and production to rise by $0.81 million (= 0.9 × 0.9 × $1 million). And so forth. Output supply expands as a geometric progression (similar to the expansion of output demand in the Keynesian case):
Alternatively, we can use equation (3.41) to solve for the change in Y. Given that dT = 0,
We can infer that a $1 million reduction in I or NX brought about by an increase in r or appreciation of the exchange rate would yield the same result.
To figure out the effect of a tax increase, we would have to know the value of g, the increase in output per unit rise in taxes. Suppose that g = 0.5, and that there is a $1 million increase in taxes. Workers, feeling poorer, expand their labor time by enough to bring about $0.5 million in new production. Given that f = 0.9, the resulting increase in production then leads to $0.45 million in further new production, then to another $0.405 million, and so on. Ultimately, production rises by
which we can calculate using equation (3.43) as follows:
These results are the opposite of what we found for the Keynesian scenario. In that case, the corrective for low employment lay in expansive monetary and fiscal policy. In this case, it lies in contractive monetary and fiscal policy.
We illustrate this in Figure 3.8. This time we have an LS curve, representing equation (3.30), which shows the different quantities of labor that workers will be willing to supply, given the amount of goods that are available to them to consume. And we have a Y curve, representing equation (3.33), which shows the different amounts of production that will be forthcoming, given the quantity of labor that workers are willing to provide to employers. Point X represents an equilibrium, insofar as OB represents just enough in output to make it worthwhile for workers to apply OA units of their effort to production, and OA represents just enough employment to make it possible for firms to produce the quantity OB.
Figure 3.8 Decrease in government spending: repressed wages case
Now suppose that point X, where the 
curve intersects the Y curve, represents a below-full-employment equilibrium. Government intervenes by reducing government purchases by dG (=XZ). This causes the LS curve to shift down by XZ, so that the economy now finds itself on 
and at a new equilibrium point W. Employment increases to OA′ and production to OB′.
The reduction in government purchases causes the LS line to shift down as workers see that they can get more consumer goods by working more. This results in the provision of more labor services, causing the excess demand for labor services to fall. As more labor services are provided, income rises and, with it, the production of consumer goods, leading workers to provide even more labor services, in a reverse of the process described earlier where we posited an increase in government purchases. This leads to an expansion of output equal to Z′X. The multiplier is Z′Z/ZX.
As before, however, we have to consider what an increase in output means for interest rates. In this instance, a contractive fiscal policy will cause Y to rise and with it the demand for money and (temporarily) the nominal interest rate. The higher interest rate will bring about some combination of reduced investment and net exports, further increasing the volume of goods available to consumers and further increasing output and employment. A contractive monetary policy will push up the interest rate (again temporarily) and cause some combination of reduced investment and net exports, again increasing employment and output.
Summing Up
When there is an excess supply of goods and labor, workers can’t find as many jobs—and their employers can’t sell as much in goods—as they could if prices and wages were adjusting as in the classical case. When there is excess demand for goods and labor, employers can’t find as many workers and workers can’t find as much in goods as they could if prices and wages were adjusting as in the classical case.
The existence of either excess supply or excess demand in the labor and goods markets will therefore cause employment and production to fall below some “normal,” market-clearing level. But which is the cause? Excess supply or excess demand?
The tradition, ever since Keynes, has been to cite the cause as excess supply. As we see, however, the existence of a low-employment equilibrium can just as well happen because supply has fallen short of demand. An economic downturn may reflect the fact that supply does not necessarily create its own demand but it may also reflect the fact that demand does not necessarily create its own supply.
Blinder puts the debate over economic policy as between supply-siders on one side and Keynesians on the other. That, however, is not the correct debate. The correct debate begins by recognizing that there is low output and low employment and therefore an unwanted state of affairs attributable to either general excess supply or general excess demand. If it is excess supply, then Blinder is right: The cure is larger deficits combined with continued monetary expansion. But if it is excess demand, then those prescriptions will worsen the problem and are, in fact, the opposite of what is needed.
The following chapter takes up the task of correctly diagnosing the problem as either excess supply or excess demand. As we will see, that task is often a difficult one to perform.
1 This differs from the Barro and Grossman’s interpretation of what they called “suppressed inflation.” They point out that the supply of labor could fall even if the real wage rate stayed constant and only because the price of goods was prevented from rising (Barro and Grossman 1974).
2 Note that the MPC and the multiplier will get smaller as Y rises. This is because changes in Y require changes in L, and Y rises at a decreasing rate as L rises. Additional units of labor will provide additional dollars of disposable income and therefore additional dollars of consumption, but the additional consumption that results from the provision of additional units of labor will decline as the amount of labor hired expands.
3 The following exposition is based on Barro and Grossman (1976) and Heijdra and Ploeg (2002).
4 Fiscal policy would be effective for expanding aggregate demand in an open economy and under fixed exchange rates. The expansion in output and the resulting rise in R would put pressure on the dollar to appreciate, forcing the monetary authorities to expand the money supply and thus to expand output.