I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text during 2013 (to be ready in draft form for second semester teaching). Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.
Previous Parts to this Chapter:
- The IS-LM Framework – Part 1
- The IS-LM Framework – Part 2
- The IS-LM Framework – Part 3
- The IS-LM Framework – Part 4
Chapter 16 – The IS-LM Framework
[PREVIOUS MATERIAL HERE IN PARTS 1 to 4]
16.6 Introducing the price level
Our derivation of the IS-LM framework initially assumed that the price level was fixed and all changes in output were real. This is consistent with the simple income-expenditure model developed in Chapter 12 where the focus was on the manner in which output and employment responds to changes in aggregate demand.
We assumed that firms were willing to supply whatever was demanded up to full capacity without changing their prices. In this vein, we also treated the nominal and real interest rate has being interchangeable.
In this section we consider how changes in the price level impact on output and interest rates.
The price level is introduced into the IS-LM framework as an exogenous variable, that is, determined outside of the interest rate-income equilibrium defined by the intersection of the IS and LM curves. There are several complications involved in adopting this assumption, which we will abstract from for the sake of simplicity.
The income-expenditure model developed in Chapter 12, which underpins the derivation of the IS curve was defined in real terms. Thus, the expenditure components – consumption, investment, government spending and net exports – are all measured in constant prices.
We would expect the IS curve therefore to be invariant to changes in the general price level given that housholds, firms, government and the external sector have made decisions regarding real expenditures.
However, to date our analysis of the money market has fudged the question of the price level. The demand for money is a demand for real balances, motivated by the need to make transactions for the exchange of goods and services which we have just noted are defined in real terms.
But, the money supply is specified in nominal terms – an amount of dollars – and forms the unit in which all the other variables are accounted.
The real value of a given stock of money on issue, however, varies with the price level. For a given stock of dollars on issue, the real value is higher when the price level is lower, and, vice versa.
For example, assume that the money supply on issue is $1000 billion and the price index is 1. The real value of the money supply would be $1,000 billion.
Now if the price level rose by 5 per cent the price index would be 1.05 and the real value of the money supply would drop to $952.4 billion.
This means that users of the currency have less available in real terms to use for purchases and speculative holdings.
The same contraction in real value of the money supply could arise if the price level was unchanged (that is, the index remained at 1) and the nominal money supply fell to $952.4 billion.
In other words, the real value of the money supply can fall if the price level rises (for a given nominal money stock) or if the nominal money stock falls (for a given price level).
Alternatively, the real value of the money supply can rise if the price level falls (for a given nominal money stock) or if the nominal money stock rises (for a given price level).
Within the logic of the IS-LM framework, it is clear that if the price level rises and reduces the real value of the money supply, the interest rate will rise because at the previous equilibrium interest rate, there will now be a shortage of real balances relative to the demand for them.
The introduction of the general price level modifies our LM curve derivation. If a rising price level (with a constant nominal money stock) is equivalent in real terms to a declining nominal stock of money (at constant prices) then we can capture this impact via shifts in the LM curve.
The LM curve shifts to the left when the price level is higher, other things equal, and to the right when the price level is lower.
Figure 16.10 depicts two different LM curves at different price levels (P1 > P0).
The introduction of the price level now means that our interest rate-income equilibrium is now contingent on the price level. If there is a different price level, the equilibrium changes as noted.
This means that within this framework, the national economy equilibrium can shift without any change in monetary or fiscal policy if the price level changes.
This observation was central to the debates between Keynes and the classical economists during the 1930s, which we examined in detail in Chapter 15.
Assume that the economy is currently at Point A, where the interest-rate is i1 and national income is Y*. The general price level is P1.
Point B is the full employment output level so that the current equilibrium is what Keynes would refer to as a underemployment equilibrium.
At Point A, the product and money markets are in equilibrium but there is an output gap and there would be mass unemployment in the labour market.
Keynes considered this to be the general case for a monetary economy and depicted the neo-classical model as a special case in which the equilibrium that emerged was also consistent with full employment. For Keynes, a monetary economy could be in equilibrium at any level of national income.
The neo-classical response to this was that unless we impose fixed wages on the model, the persistent mass unemployment would eventually lead to falling nominal wages and prices.
While this might not lead to a fall in the real wage (if nominal wages and prices fall proportionately), which would negate the traditional neo-classical route to full employment via marginal productivity theory, the fact remains that the lower price level increases real balances in the economy.
The reasoning that follows is that the reduction in prices leads to a decline in the transactions demand for money at every level of income because goods and services are now cheaper.
With the nominal stock of money fixed, the expansion of real balances combined with a decline in the demand for liquidity, results in a decline in the rate of interest.
As long as future expectations of returns are not affected adversely by the deflationary environment, the reduction in the rate of interest, stimulates investment spending, which leads to increased aggregate output and income via the multiplier effect.
As long as there is an output gap, deflation will continue and the interest rate will continue to fall until the economy is at full employment.
The link between real balances and the interest rate was referred to as the Keynes effect.
In terms of Figure 16.10, the LM curve shifts outwards as the price level falls and the rising investment is depicted as a movement along the IS curve. The new equilibrium is Point A.
This observation then led to neo-classical economists to consider the possibility of an underemployment equilibrium as a special case when wages and prices were fixed.
The view that Keynes’ underemployment equilibrium was a special case of the more general flexible price model became known as the Neo-classical synthesis. This approached recognised that aggregate demand drove income and employment (the so-called Keynesian contribution) but that the economy would tend to full employment if wages and prices were flexible (the Classical contribution).
There are several arguments against the view that a Keynes effect will be sufficient to generate full employment.
Keynes’ General Theory, – Chapter 19 – which is devoted to the impacts of money wage changes on aggregate demand.
Among other impacts, Keynes argued that lower money wages and prices will lead to a redistribution of real income (FIND PAGE NUMBERS):
(a) from wage-earners to other factors entering into marginal prime cost whose remuneration has not been reduced, and (b) from entrepreneurs to rentiers to whom a certain income fixed in terms of money has been guaranteed.
He concluded that the impact of “this redistribution on the propensity to consume for the community as a whole” would probably be more “adverse than favourable”.
Moreover, falling money wages will have a (FIND PAGE NUMBERS):
… depressing influence on entrepreneurs of their greater burden of debt may partly offset any cheerful reactions from the reduction of wages. Indeed if the fall of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency, — with severely adverse effects on investment.
Overall, Keynes concluded that there was “no ground for the belief that a flexible wage policy is capable of maintaining a state of continuous full employment”.
The debt-deflation argument was also recognised by other economists such as Irving Fisher in 1933, Michal Kalecki in 1944 and Hyman Minsky in 1982).
[TO BE CONTINUED IN PART 6]
PART 6 next week – CRITIQUE OF FRAMEWORK.
The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty (-:
That is enough for today!
(c) Copyright 2013 Bill Mitchell. All Rights Reserved.