I have noted in recent weeks a periodic reference to long-run neutrality of money. Several readers have written to me to explain this evidently jargon-laden concept that has pervaded mainstream economics for two centuries and has been used throughout that history, in different ways, to justify the case against policy-activism by government in the face of mass unemployment. It is once again being invoked by the deficit terrorists to justify fiscal austerity despite the millions of productive workers who remain unemployed. I have been working on a new book over the last few days which includes some of the theoretical debates that accompany the notion of neutrality. There will also be a chapter in the macroeconomics text book that Randy Wray and I are working on at present on this topic. Essentially, it involves an understanding of what has been called the “classical dichotomy”. It is a highly technical literature and that makes it easy to follow if you are good at mathematical reasoning. It is harder to explain it in words but here goes. I have tried to write this as technically low-brow as I can. The bottom line takeaway – the assertion that money is neutral in the long-run is a nonsensical contrivance that the mainstream invoke to advance their ideological agenda against government intervention. It is theoretically bereft and empirical irrelevant. That conclusion should interest you! But be warned – this is just an introduction to a very complex literature that spans 200 years or so.
In a pamphlet to support Lloyd George in the 1929 British election, J.M. Keynes wrote:
The Conservative belief that there is some law of nature which prevents men from being employed, that it is ‘rash’ to employ men, and that it is financially ‘sound’ to maintain a tenth of the population in idleness is crazily improbable – the sort of thing which no man could believe who had not had his head fuddled with nonsense for years and years.
When I started learning economics, there was high unemployment in most advanced economies (second-half of 1970s). Given the massive waste that unemployment involves I was curious as to how the mainstream economics profession could on the one hand argue that the absence of government intervention would allow the optimal allocation of resources yet it was obvious from history that whenever governments used their fiscal powers to generate spending (aggregate demand) unemployment fell.
It was clear as I learned more that the mainstream theory was preposterous. It justified mass unemployment by claiming it was a voluntary phenomena arising out of free and maximising behaviour by the unemployed who were cast as preferring leisure at that point in time to work (and income). In that sense, high unemployment was “full employment” because it was a chosen state.
That allowed the models they used to indoctrinate students with to assume full employment as a starting point. Yes, there were some economists who could see the business cycle. But this was just a transient deviation around the “long-run” trend. There was a sequence of interrelated theories that claimed this was optimal and inevitable and any efforts by government to divert this “natural” tendency would result in inflation.
Accordingly, we were presented with the classical dichotomy or classical neutrality that said that nominal variables in the economy (money stock, prices) were independent of the real variables (employment, production etc) in the long-run. Extreme versions (rational expectations) later denied any relationship between the nominal and the real at any time! So the short-run was the long-run.
So if you wanted to understand the evolution of real output or employment then you needed no knowledge of the monetary system (or money). The rate of inflation was a purely monetary phenomenon and was analysed separately from the state of production.
The other way of saying this is that money is neutral (with respect to the real economy) and changes in the stock of money did not affect the real economy – only the rate of inflation. This was the Classical position that dominated economic theory until the Great Depression in the 1930s and although Marx had demolished it in the C19th, it took the work of Keynes and Kalecki in the 1930s to really expose its mythical nature.
So the Classical economists considered money to be a “veil” over the real economy that could be lifted without losing any insights. Moreover, if money is neutral in the long-run then governments could not hope to influence the real economy by manipulating the stock of money. So if the government thought the unemployment rate was too high and tried to expand aggregate demand (operating under the assumption that spending equals income equals output) then the classical dichotomy claimed this action would be futile and result in ever-accelerating inflation.
I outlined the labour market theory that underlies the classical dichotomy in this blog – Less income, less work, less income, more work!.
The mainstream analysis divides households (consumers) and firms (producers) and fudges the so-called aggregation problem (adding all these different entities up) by dealing with average agent – representative agent which is constructed as being rational and maximising in all their decision making. Behavioural theory refutes that assumption but the mainstream have rarely consulted psychology. They just assert this type of behaviour irrespective of the evidence.
All these agents are price takers in all markets – that is, there is perfect competition and no firm has any price setting power.
What determines employment? The simple classical model used what was called the Corn model to derive the classical dichotomy. They claimed that to examine household choice, we only need to know: (a) the initial goods endowment (wealth); (b) the terms of exchange between goods; and (c) Tastes and preferences of households. The first two define household income.
They consider two goods: (a) Corn (C); and (b) Leisure (L). The relative price of leisure is number of units of C that you give up to have one unit of L. Giving up L involves offering equal units of labour so relative price of leisure is the real wage rate, w. The relative price of corn is thus 1/w.
So the workers are deemed to have a labour-leisure choice (per day).
In Chapters 2 and 7 of my 2008 book with Joan Muysken – Full Employment abandoned – we consider the Classical labour market which is the basis of the standard Classical view on unemployment.
The Classical/neo-classical model is represented by the following figure:
For those who like equations, the lines in the graph can be written in algebraic form as follows:
Labour demand: Ld = f(w) f’ < 0
Labour supply: Ls = f(w) f’ > 0
Equilibrium: Ld = Ls
where w is the real wage which is the ratio of the nominal wage, W and the price level P.
The real wage is considered to be determined in the labour market, that is, exclusively by labour demand and labour supply. Keynes showed that this assumption is clearly false. It is obvious that the nominal wage is determined in the labour market and the real wage is not known until producers set prices in the product market (that is, in the shops etc).
The labour supply (Ls) function, which is based on the idea that the worker has a choice between work (a bad) and leisure (a good), with work being tolerated only to gain income (in the simple model – units of Corn). The relative price mediating this choice (between work and leisure) is the real wage which measures the price of leisure relative to income. That is an extra hour of leisure “costs” the real wage that the worker could have earned in that hour. So as the price of leisure rises the willingness to enjoy it declines.
The worker is conceived of at all times making very complicated calculations – which are described by the mainstream economists as setting the “marginal rate of substitution between consumption and leisure equals to the real wage”. This means that the worker is alleged to have a coherent hour by hour schedule calibrating how much dissatisfaction he/she gets from working and how much satisfaction (utility) he/she gets from not working (enjoying leisure). The real wage is the vehicle to render these two competing uses of time compatible at a work allocation where the worker maximises satisfaction.
What happens when the relative price between C and L changes? The final result looks scientific but is in actual fact a total fudge.
They isolate two separate “effects” of such a real wage change (say a rise): (a) a substitution effect; and (b) an income effect.
So an increase in the real wage (more corn is foregone for an hour of leisure) leads the worker to consume less leisure and to work more. This is the substitution effect. So if the real wage rises, work becomes relatively cheaper (compared to leisure) and the mainstream theory asserts via the so-called law of demand that people demand less of a good when its relative price rises. So real wage up, less leisure, more work.
But there is another effect to consider – the so-called income effect. When the real wage rises, the worker now has more income for a given number of hours of work.
The mainstream theory of normal goods (as opposed to inferior goods – the distinction is just made up largely) tells us that when income rises a consumer will consume more of all normal goods. The opposite is the case for an inferior good.
Leisure is considered to be a normal good as are other consumption goods the worker might buy with the income he/she earns. So as the real wage rises, the income effect suggests that the worker will demand more of all normal goods (because they have higher incomes for a given number of working hours) including leisure. That is the worker will work less and consume more leisure.
What is the net result? No analytical solution is provided. They just assert that the relative price (substitution) effect is stronger than the income effect and so the labour supply curve is upward sloping. It is totally made up result and no robust empirical analysis has supported this assertion. The reason they need to assert this result is because they also assert the demand curve is downward sloping and for an “equilibrium” they need the curves to cross. Simple as that.
The model assumes there are millions of firms and labour is one factor of production and indistinguishable from any other (inanimate) input. The single good is produced (Corn). Technology defines a “production function” which maps how much output is gained by adding successive units of input to a “fixed” stock of capital.
The labour demand (Ld) function is the “derivative” of the production function with respect to labour input (the marginal product). The ad hoc imposition of the so-called law of diminishing returns ensures this derivative is positive but declining as employment is increased.
In English, they say that as extra units of labour are added to a fixed stock of capital they become increasingly unproductive and hence there is diminishing products (returns). Hence, the labour demand function is downward sloping with respect to real wages. The argument is that firms have to pay the real wage (an amount of actual product) to the marginal workers and so they will only hire extra labour if the amount the worker contributes to production is more than the real wage. The assertion of diminishing returns assures the demand curve will be downward sloping – so the firm will only be prepared to hire extra workers if the real wage is reduced.
The following diagram shows the relationship between the labour market (top) and the production function (bottom). Here I am using Y to denote GDP and N to denote aggregate employment, The convex shape of the “production function” defines the assertion that there are diminishing returns. I will come back to this graph in moment.
The production function is a “short-run” relationship based on the fixity of other inputs like capital. In the real world, production processes rarely follow the model presented in the textbook. First, the idea that capital is fixed and production expands purely because extra workers are added seems not a reasonable depiction of reality. A cleaning firm who finds extra contracts do not force extra workers to share a single broom or vacuum cleaner. If there is extra work they add a worker and another broom!
So we have what are called “fixed factor proportions” which is just a fancy phrase meaning that workers and capital are added to production more or less in proportion dictated by the current technology. In that case, each additional worker is more or less as productive as the last. There is very little evidence in the real world to support the ad hoc assertion of the “law of diminishing returns”. It always amused me when I was a student how the mainstream attempted to infuse levity into their inane theories by referring to them as “laws” akin to a physical law in physics.
Once you see through this and realise that they are just assertions that these characters dream up (invent) which stand and fall on their empirical applicability you start seeing the nakedness ugliness of the neo-classical theory.
Anyway, the labour demand hiring rule is based on the assumption that firms always maximise profits and in the output market set prices equal to marginal cost (that is, the last unit of revenue they gain (price) is equal to the cost of producing that last unit of output). They cannot do better than that!
This rule translates into a labour hiring rule by noting that marginal costs (MC) equals the nominal wage (W) divided by the marginal product (MP, the extra unit of output per worker employed). So P = W/MP. Re-arranging this gives W/P = MP which is the famous marginal product hiring rule and says in English that firms will hire up to the point where what it costs them in real terms (the real wage – W/P or w) is exactly equal to what they get from the last unit of labour hired (MP).
Given the assertion of diminishing marginal products the firms know that as the real wage falls (on the vertical axis of the labour market diagram) firms will hire an additional worker (who is less productive at margin than last hired).
If you put the supply and demand ideas together you get the classical labour market which guarantees continuous full employment. With no borrowing or lending (simplifying assumption), then a price adjusting economy (if excess demand, price rises) will always guarantee full employment. If there is unemployment (that is an excess supply of labour) then the real wage will fall and vice versa.
In the corn economy this is a simple proposition. If there are workers wanting a job who do not have one then the corn wage falls and firms react by hiring more workers because it is profitable to do so at the lower rate. The corn wage falls until all those who want to work have a job.
Once money is introduced and the real wage is a combination of the money wage and the price level (which are determined in separate markets) then the analysis becomes more difficult.
The important point is that the classical labour market (which underpins the classical dichotomy) denies that involuntary unemployment can exist.
Why? Answer: Instantaneous price adjustment (real wage) keeps economy at full employment. Can there be generalised over-production? Answer: no! How do we know that the output produced by the full employment labour hiring (and capital usage) will be demanded in the goods market? Answer: Say’s law.
Say’s Law asserted that there was no possibility of general over-production. The trivial statement was that supply creates its own demand. This is a trivial point if we are in a barter economy with no borrowing or lending. More later on that.
To see the point consider the determination of aggregates in the Corn model. Reflect back on the two-panel diagram above. The model is entirely in real terms and there is no “price level” or “money” involved. The real system is totally determined by these two relationships.
If we know the market clearing real wage then the system is solved. We know the real wage(w), total employment (N), real GDP (Y), and real aggregate demand (AD). In the latter case, the AD curve would be identical to aggregate supply (AS) curve because supply creates its own demand or, in other words, the product market always clears.
In the bottom panel, technology sets the position of the production function. Market clearing determines the real wage and the employment level in the top panel. This employment level then determines a level of output via the production function deterministically.
This level of real output is all sold because of the assertion of Say’s law. So the real system is determined with reference to money. We do not have a “price level” in this economy and to explain prices (and inflation) the classical economists then had to introduce money. But the important point is that in dealing with a “money” economy the classical economists still asserted the dichotomy – the real sector was determined independent of the “price” level.
So Classical employment theory thus denies unemployment. The classical dichotomy was built on a denial of mass unemployment. The persistence of mass unemployment thus is extremely problematic for their theory and more practical approaches claimed it was a short-run phenomena due to market forces (that is, price clearing) being thwarted by government policy (for example, minimum wages) or trade unions etc. These fundamental institutions of capitalism were thus cast off as “market imperfections” which would disappear in the “long-run” as competitive forces eroded them.
What happens if we introduce borrowing and lending into the simple Corn model.
Borrowing is constructed as the supply of (private) bonds whereas lending is the buying of bonds. A bond is an asset which is a promise to pay corn at some specified future date. Previously, to provide for future consumption a person had to save corn (not consume current production). Now a person can purchase bonds that will yield future income flows (for consumption). So the assets that are now available in this more complex model are: (a) Bonds; and (b) Corn savings
The impact of this was that saving (S) was now identically equal to investment (I) now for any one individual. One can invest more than one saves and save more than one invests. Further it is no longer true that the only way to invest is to save (and the only way to save is to invest). With 2 assets we have S = I + Lending.
But if there is to be no general overproduction then what is not consumed has to be invested. In the simple Corn model if workers didn’t eat a Corn seed they would automatically plant it (that is, invest it). But with borrowing and lending permitted the situation was more complicated.
The point is that for the product market to clear (that is, aggregate demand to equal aggregate supply) saving (S) still had to equal investment (I). How did the classical economists assert that this situation would be continuously achieved (that is, full employment would be continuously maintained)?
Answer: introduce the theory of loanable funds, which is a aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking. The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.
You will find this theory still being peddled (and applied to our financial markets) in most mainstream macroeconomics textbooks today (including Mankiw).
Mankiw assumes that it is reasonable to represent the financial system as the “market for loanable funds” where “all savers go to this market to deposit their savings, and all borrowers go to this market to get their loans. In this market, there is one interest rate, which is both the return to saving and the cost of borrowing.”
This is back in the pre-Keynesian world of the loanable funds doctrine (first developed by Wicksell).
This doctrine was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times. If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving. So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded. The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.
The following diagram shows the market for loanable funds. The current real interest rate that balances supply (saving) and demand (investment) is 5 per cent (the equilibrium rate). The supply of funds comes from those people who have some extra income they want to save and lend out. The demand for funds comes from households and firms who wish to borrow to invest (houses, factories, equipment etc). The interest rate is the price of the loan and the return on savings and thus the supply and demand curves (lines) take the shape they do.
Firms were assumed to invest and households assumed to save. The question was how do these disparate decisions of each group coincide given they have different motives? The assumption is that the average firm is a net borrower (to fund capital) and a net bond issuer while the average household is a net lender (purchaser of bonds).
So what determines consumption and savings? Borrowing and lending are called inter-temporal exchange. What determines saving? Saving is constructed as a function of the real interest rate (which calibrates how many units of corn you have to give up now for future corn). What are the terms that this exchange occurs?
The real interest rate is a relative price (current for future corn) – that is, the relative price of today’s corn income is the number of units of corn that an individual will receive in the future if that individual gives up one unit of today’s corn. It is obviously going to be greater than unity.
The excess over unity is the interest rate. So relative price of today’s corn is 1 + i. The relative price of today’s corn is = 1 + i. Relative price of next period corn is the number of units of corn that the person gives up today to get one unit next period = 1/(1 + i) < 1. What does the saving function look like for a household (net saver)? Here the same sort of decomposition that we saw above in the labour supply decision is invoked. If the interest rate rises, the relative price of today’s corn rises and two effects can be decomposed: rises and two effects occur: (a) Substitution effect - saving rises; and (b) Income effect (wealthier) - saving falls. The mainstream just assert that the substitution effect is greater than the income effect and so as the interest rate rises, consumption falls. In terms of the investment function, investment is seen as a negative function of the interest rate. Note that the entire analysis is in real terms with the real interest rate equal to the nominal rate minus the inflation rate. This is because inflation “erodes the value of money” which has different consequences for savers and investors. Mankiw claims that this “market works much like other markets in the economy” and thus argues that (Principles, p. 551):
The adjustment of the interest rate to the equilibrium occurs for the usual reasons. If the interest rate were lower than the equilibrium level, the quantity of loanable funds supplied would be less than the quantity of loanable funds demanded. The resulting shortage … would encourage lenders to raise the interest rate they charge.
The converse then follows if the interest rate is above the equilibrium.
The interest rate coordinates the separate saving and investment decisions and brings the net lenders (households) and net borrowers (firms) together to ensure equilibrium. If for example, S > I, i falls and the market clears. If S < I, i rises and the market clears So Say’s Law is maintained and interest rate is a real variable (not a monetary variable). By way of summary, real output is determined by the current state of productivity (technology) and the level of employment that clears the market. It is thus supply constrained only by the available supply of labour and the state of technology. Real wage flexibility maintains full employment. Say’s Law is maintained by interest rate flexibility in the loans market. So this analysis to date describes the way the mainstream outlined the determination of the real sector. What determines the price level (the nominal values of these real variables) in the Classical system?
In answering this question we explore the full meaning of the “classical dichotomy”. The principle framework used to explain the price level was the Quantity Theory of Money (QTM).
Quantity Theory of Money was used by Classical economists to explain the price of goods. The value of money = 1/p (the inverse of the price level) is determined by demand for and supply of money. There were two versions of this theory: (a) the flow version – Irving Fisher; and (b) the stock version – Marshall, Pigou and Keynes (so-called Cambridge equation).
The flow version is straightforward and best known by lay audiences and is still used by those who want to draw a connection between the money supply (or its rate of growth) and inflation.
In the Classical model, the price level is determined by: MV = PY
M = stock of money balances; V = velocity of circulation (how many times per period the stock of money turns over in transactions); Y = full employment output and P = price level. PY is nominal GDP.
MV is the flow of $s per period and PY is the flow aggregate demand of $s per period. If you think about the MV = PY equation then from a transactional viewpoint it has to hold. It is an accounting statement. All the transactions (left-hand side) have to equal the value of production (right-hand side). That doesn’t get us very far.
What the Classical economists wanted to assert was that if MV > PY then the change in prices was assumed to be positive, and if MV < PY then the price level would fall. Clearly, a steady-state situation was when MV = PY. To explain the price level (P) the Classical economists had to impose behavioural stipulations on V (fixed) and full employment (Y fixed). Then it became clear that the change in M would directly impact on the change in P (that is, inflation).
So Classical theorists (and monetarists and more modern variants) had to make some assumptions or assertions about the behavioural nature of the variables underlying the accounting identity. So they assumed that V is constant and ground in the habits of commerce – despite the empirical evidence which shows it is highly variable if not erratic.
They also assumed that Y will always be at full employment because they invoke flexible price models and assume market clearing – so they take Y to be fixed. This just asserts the real model derived above which includes the denial of unemployment.
This is a case of blind devotion to theory stopping the economist looking out the window and seeing regular periods when productive resources are anything but fully employed.
But with these assumptions – any child could then conclude that changes in M => directly lead to changes in P because with V assumed fixed the left-hand side is driven by M and if Y is assumed to always be at full employment then the only thing that can give on the right-hand side of the accounting identity is P.
While first-year students struggle to learn this theory and think it is high science – it is almost mindless when you think about it. You should easily be able to see the flaws.
The assertion that the real side of the economy (output and employment) are completely separable from the nominal (money) side and that prices are driven by monetary growth and growth and employment is driven wholly by the supply side (technology and population growth), rests on the assertion that the economy is always at full employment (quite apart from the nonsensical assumption that V is fixed).
Anyone with a brain could tell you that if business firms can respond to higher nominal spending (that is, higher $ demand) – either by increasing production or increasing prices or increasing both – and they cannot increase production any more (because the economy is at full employment) then they must increase prices to ration the demand.
That is a basic presumption of modern monetary theory (MMT). But typically, firms prefer to respond to demand growth in real terms to maintain their market share and thus invest in new capacity if they think spending will grow in the future and vice versa.
The overwhelming evidence is that the macroeconomy quantity adjusts rather than price adjusts to nominal aggregate demand fluctuations when there is excess capacity. Otherwise firms risk losing market share.
So, when the economy is in a state of low capacity utilisation with significant stocks of idle productive resources (of all types) then it is highly unlikely that the firm will respond to a positive demand impulse by putting up prices (above the level that they were before the downturn began). They might stop offering fire sale prices but that is not what we are talking about here.
This should discourage you from automatically linking growth in the monetary base and inflation. There is no link.
Inflation is driven by nominal aggregate demand growth that exceeds the capacity of the economy to respond in real terms – that is, to increase output. There are a myriad of reasons why this situation could emerge and some of these reasons implicate poor government policy decisions.
I really liked the way that Michel Kalecki developed the critique of Say’s law. In 1964 Kalecki (in his ‘Why Economics Is Not an Exact Science’, PP, 9, 62-65) offered this view:
This law asserts, speaking roughly, that all incomes, wages or profits are fully spent on the purchase of goods and services. This is self-evident as afar as expenditure on consumption is concerned while accumulation is treated as being always spent on investment. This doctrine obviously rules out the possibility of general overproduction, total demand is always equal to total supply. The law has certain affinities with the laws of preservation of matter and energy. The difference, however, is that it is definitely wrong. It implies that the value of national income is constant. If, for instance, less is spent on consumption then pro tanto more is spent on investment. But it was always clear that this is not the case since the value national income is subject to abrupt changes … Any divergence from Say’s law was interpreted as a divergence of the actual rate of interest from the equilibrium rate. It took a long time to realize that the idea of a rate of equilibrium was totally misconceived since the actual rate of interest had nothing to do with it. To discard the law of the preservation of purchasing power meant admitting the possibility of general overproduction. In particular investment may be lower than the accumulation corresponding to full utilisation of productive resources since its volume is determined by altogether different factors. This leads to piling up of unsold goods. A situation of this kind cannot, obviously, continue for long and is soon followed by a state of underutilization of resources …
How could the belief in the preservation of purchasing power be maintained for so long? In my view for two basic reasons: the class interests of the capitalists and the apparent corroboration of the law by experience of the individual. A doctrine which ruled out general overproduction made the capitalist system appear capable of full utilization of productive resources and dismissed cyclical fluctuations as insignificant frictions. These apologetics were facilitated by the application to the economy as a whole of the experience of housekeeping where clearly a lesser consumption means higher saving. But whereas the income of the individual is given, the national income is determined in a capitalist system by consumption and investment decisions, a fall in one of these components by no means leading automatically to a rise in the other. Thus individual experience does not correspond to the course of the economy as a whole.
So from that very insightful passage you learn a lot of things about macroeconomics that can be applied to understanding the present situation.
First, there is a strong recognition of the way in which the presence of compositional fallacies deceives the mainstream analysis. What applies at the individual (micro) level does not apply at the aggregate (macro) level. Please read my blog – Fiscal austerity – the newest fallacy of composition – for more discussion on this point.
Second, inherent in Kalecki’s work is a split between the long- and short-run but unlike the mainstream (Say’s law) there is no notion that the long-run is a steady-state attractor (that is, a (natural) point that the macroeconomy gravitates to when imperfections are eliminated). Kalecki’s notion of the long-run bore no insinuation of “equilibrium” (competitive equalisation of rates of profit; realised expectations; full employment).
Rather he sees the long-run as a sequence of short-run situations and the long-run influences are manifest and developed within the short-run. What are these long-run forces? Answer: factors that have an enduring influence on the path the economy takes. So these factors are evident by the sequence of short-run situations and so analytically it is impossible to decompose the long-run from the short-run.
He argued factors such as the institutional characteristics of the nation, market concentration, technological change and the class struggle between workers and capital were such long-run factors.
For example, Kalecki’s income distribution analysis was unique for his day because he eschewed the perfect competitive model as a starting point in analysing firm behaviour and price setting. He considered oligopoly (imperfect market competition) to be the norm (that is, concentrated markets where firms had price-setting power). He then wanted to know what determined the firm’s price setting power. In the mainstream, firms are initially cast as having no price-setting discretion as they are perfectly competitive.
Kalecki also began with the observation that full employment was an exception not the rule so firms typically had spare capacity and thus could expand output as demand increased at more or less constant unit costs. In the competitive model firms are always assumed to be oprating at full capacity and face increasing unit costs and so prices rise when demand rises. The real world fits the Kalecki starting point.
In considering the determinants of the “mark-up” that these empowered firms placed on their unit costs, Kalecki interwove his long-run factors with the short-run factors. It is a great example of the way in which he considered it impossible to really differentiate a separate analytical long-term temporal plane.
He said that the degree of industrial concentration (how many firms in a market etc) was inversely related to price-setting power. This is a “long-run” influence because changes in concentration move slowly. However, the business cycle is interposed on these underlying factors and are considered “short-run” factors. So when the economy turns downwards, the capacity of firms to pass on price rises is strained and so the mark-up may be squeezed. Further, while the class struggle underlies the determination of the output distribution, this is, in itself, mediated by the state of the business cycle – so when times a good, unions are stronger than when times are bad.
So you get a good picture of the way he eschewed the mainstream (neo-classical) long-run from these examples.
In fact, the long run trend is but a slowly changing component of a chain of short run situations; it has no independent entity …
Some mainstream economists assert that while price rigidities can render the real economy susceptible to changes in the money supply (positive effect) in the long-run, when all these rigidities are eliminated the classical dichotomy asserts itself.
Clearly, Kalecki didn’t agree with that. The concept of a separable “long-run” in highly dubious.
I particularly like this construction:
In sum, in neoclassical economics the “long run” cannot be a temporal concept. It does not refer to any real world process of evolution or change. Even notional processes are shown to be difficult to conceive. “Long run,” by definition, refers to a situation in which no mistakes are made and all the (theoretically expected) adjustments are achieved. It is not in time, it is not even a secular trend. It is just an aprioristic statement of what the world would look like should the theory be correct (emphasis in the original).
The source is Fernando Carvalho (1984-85) ‘Alternative Analyses of Short and Long Run in Post Keynesian Economics’, Journal of Post Keynesian Economics, 7(2), 214-234. For those who have access to JSTOR the link is HERE.
The transmission mechanism that linked the excess supply of money with the excess demand for goods was as follows.
People who hold more “money” than they desire will will eliminate the excess by (a) Directly buying goods and services; (b) Lending the excess supply of money (shift supply of loans) and lower the interest rate and stimulate investment.
This will create an excess demand for goods and prices rise because the economy is already at full employment (by assumption).
Classical dichotomy and the denial of unemployment
So at the heart of the classical system was the classical dichotomy and the QTM was used to generate a theory of absolute price levels while general equilibrium theory was used to generate a theory of relative price determination for the ‘real’ economy in which money was excluded.
In this regard, Walras’ Law provided the foundation of relative price theory. It is the basic principle linking together the goods market, the labour market, the bonds market and the money market.
Walras’ Law requires that the sum of excess demands and excess supplies overall all markets to be identically equal to 0. Thus for unemployment to exist (which would be an excess supply of labour) then by Walras’ Law there must be an excess demand in another market.
So Walras’ Law extends Say’s Law and includes all markets in the aggregation. They invoked what they called the “homogeneity postulate” which just says that the demands and excess demands in all the markets will not change in response to a change in the absolute price level on its own.
The technical term is that the demand functions are homogenous of degree zero in money prices. Accordingly, if relative prices remain unchanged, the demand for a particular commodity will not change when the overall price level changes. Demand functions are thus dependent only on relative prices.
Once an equilibrium is defined as a situation where in each market is in equilibrium (all excess demands are zero) then Walras’ law shows that equilibrium is defined purely in terms of a set of relative prices because the absolute price level can have no real effects. A proportionate change in all prices will not alter the equilibrium.
Thus the QTM is used to determine the absolute price level while the Walrasian GE model determines relative prices.
But the integration of the two approaches is very problematic although that gets too technical for this audience. Maybe another day I will have more time to weave a narrative around the mathematics!
What follows is that the money value of all planned market purchases (summed) are identically equal to the aggregate money value of all planned market sales. The implications of this for an economy-wide analysis were that equilibrium was considered to generalise across all markets. A single market could not be in disequlibrium alone.
This result was used to examine what happens when there is an excess supply of laboru in one market (that is, a disequilibrium). If the nth market is in disequilibrium then there must be an offsetting disequilibrium in at least one other market. This is Walras’ Law.
If there is excess supply in one market then there must corresponding to this be positive excess demand in at least one other market. Important to notice that the excess demands and supplies are measured as differences between planned (or notional) demands and supplies and not necessarily actual demands and supplies).
What is the relevance of this? Answer: Walras’ Law is crucial for understanding different constructions of how unemployment occurs in the mainstream approach and provides a more sophisticated version of the simple “workers are lazy”.
A Walrasian would say that either all markets are in equilibrium, or more than one is in disequilibrium, but we can’t have a situation where only one market is in a state of excess supply.
This is in conflict with Keynes’ own claim that excess supply in the labour market can be an equilibrium and thus a persistent state of affairs in a (free) market economy.
So for a Walrasian, involuntary unemployment cannot persist in a market economy with flexible wages and prices. The excess demand in the product market (accompanying the excess supply in the labour market) will drive prices up until excess demands are exhausted. The excess labour supply will push money wages down. Together, the real wage falls and this removes the excess supply of labour.
So unemployment cannot be a persistent equilibrium that the economy tends to.
So an excess supply of labour (unemployment) must be accompanied by an offsetting excess demand elsewhere (say for commodities). According to this story, the unemployed workers must have been intending to buy something with the wages they hoped to earn.
So the question then is why the bosses won’t hire the workers given that the demands for commodities exactly offsets the supply of labour.
Clue: the Keynesian re-appraisal which built on insights provided earlier by Marx and then Keynes (as well as others).
Macroeconomics emerged in the 1930s out of the failure of mainstream economics to conceptualise economy-wide problems – in particular, the problem of mass unemployment. Marx had already worked this out many years earlier.
In Theories of Surplus Value – Chapter XVII entitled Ricardo’s Theory of Accumulation and a Critique of it, Marx confronted Ricardo’s contention that there could never be a general glut in the market (which in modern terminology relates to a deficiency of aggregate demand).
Marx summarised Ricardo’s claim as follows:
more of a particular commodity may be produced than can be consumed of it; but this cannot apply to all commodities at the same time. Because the needs, which the commodities satisfy, have no limits and all these needs are not satisfied at the same time. On the contrary. The fulfilment of one need makes another, so to speak, latent. Thus nothing is required, but the means to satisfy these wants, and these means can only be provided through an increase in production. Hence no general overproduction is possible.
This was the logic behind Say’s Law which posited that “supply brings forth its own demand” and so macroeconomic crises (and unemployment) could not occur. It is also the logic behind the loanable funds doctrine which is still the basis of the claim that rising budget deficits lead to rising interest rates.
In developing his own explanation of how economic crises occur as a result of a failure of aggregate demand, Marx said:
Could there be a more childish argument? … In periods of over-production, a large part of the nation (especially the working class) is less well provided than ever with corn, shoes etc., not to speak of wine and furniture. If over-production could only occur when all the members of a nation had satisfied even their most urgent needs, there could never, in the history of bourgeois society up to now, have been a state of general over-production or even of partial over-production. When, for instance, the market is glutted by shoes or calicoes or wines or colonial products, does this perhaps mean that four-sixths of the nation have more than satisfied their needs in shoes, calicoes etc.? What after all has over-production to do with absolute needs? It is only concerned with demand that is backed by ability to pay. It is not a question of absolute over-production – over-production as such in relation to the absolute need or the desire to possess commodities. In this sense there is neither partial nor general over-production; and the one is not opposed to the other.
In the wider context of the development of economic theory, the development of Marx’s arguments in TSV were prescient indeed. The idea that capacity to pay was the key to understanding crises underpinned the notion of effective demand that appeared in the writings of Keynes and his contemporaries some 70 odd years later. It is the basis of the famous attack against the emerging monetarism of Friedman and others by Robert Clower and Axel Leijonhfuvd in the 1960s where they noted the difference between notional and effective demands and supplies. Marx had worked all that out 100 years earlier.
The more recent chapters in the debate constituted the Keynesian reappraisal.
In the 1950s, particularly, there was a major debate proceeding concerning the microfoundations of macroeconomics. As noted above, the neoclassical paradigm hardly considered macroeconomics to be a separate conceptual structure to microeconomics. The emergence of Keynesian economics in the 1930s had coincided with the emergence of macroeconomics as a separate line of enquiry.
The break with neoclassical thinking came with the failure of markets to resolve the persistently high unemployment during the 1930s. The debate in the ensuing years were largely about the existence of involuntary unemployment. The 1930s experience suggested that Say’s Law, which was the macroeconomic component and closure of the neoclassical system based on the optimising behaviour of individuals, did not hold.
The neoclassical economists continued to assert that unemployment was voluntary and optimal but that some factors not previously included in the model prevented Say’s Law from working. Keynes, following Marx and Kalecki, adopted the distinctly anti-orthodox approach and refuted the basis of Say’s Law entirely.
Marx was the first to really understand the notion of effective demand – in his distinction between a notional demand for a good (a desire) and an effective demand (one that is backed with cash). This distinction, of-course, was the basis of Keynes’ work and later debates in the 1960s where Clower and Axel Leijonhufvud demolished mainstream attempts to undermine the contribution of Keynes by advancing a sophisticated monetary understanding of the General Theory.
Bob Clower and Axel Leijonhufvud separately attacked the relevance of Walras Law for situations in which there is involuntary unemployment.
The theoretical push to reassert Say’s Law by neoclassical economists was severely dented by the work of Clower (1965) and Leijonhufvud (1968). They demonstrated, in different ways, how neoclassical models of optimising behaviour were flawed when applied to macroeconomic issues like mass unemployment.
They agreed that it is correct to say that in aggregate an excess of planned supply in one market must be matched by an excess of planned demand in at least one other market. But, they argued that Walras’ Law measures excess demands and supplies as differences between planned (notional) demands and supplies. These are not actual (effective) demands and supplies.
Keynes maintained that there can be conditions under which excess demands (or supplies) will not be effectively communicated in the market. So although certain prices (including wages) are at disequilibrium levels, no process of bidding them away from these inappropriate levels will get started. In particular, the excess demand for commodities is not effective market failure. It persists because “the market signals, pre-supposed in general equilibrium analysis are not transmitted” (Leijonhufvud, 1981: 70).
Clower (1965) showed that an excess supply in the labour market (unemployment) was not usually accompanied by an excess demand elsewhere in the economy, especially in the product market. Excess demands are expressed in money terms. How could an unemployed worker (who had notional or latent product demands) signal to an employer (a seller in the product market) their demand intentions?
Leijonhufvud (1968) added the idea that in disequlibrium price adjustment is sluggish relative to quantity adjustment. Leijonhufvud interpreted Keynes’s concept of equilibrium as being actually better considered to be a persistent disequilibrium. Accordingly, involuntary unemployment arises because the labour market is not in equilibrium and there is no way that the unemployed workers can signal that they would buy more goods and services if they were employed.
Any particular firm cannot assume their revenue will rise if they put a worker on even though revenue in general will clearly rise (because there will be higher incomes and higher demand). The market signalling process thus breaks down and the economy stagnates.
This blog aimed to introduce you clearly to the notion of the classical dichotomy which is based on the assertion that the real economy can be analysed completely separately from an analysis of price level determination. The sinister side of the dichotomy is that it underpins a case for zero policy intervention because it assumes full employment.
Any unemployment that is observed must be transient (policy interfering with market forces) or voluntary (leisure preferred over work). According to this theoretical structure, in the “long-run” money and inflation are proportional (and causal from money to prices) and government intervention designed to lower the unemployment rate is purely inflationary.
The framework fails theoretically and has no empirical content.
That is enough for today!