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3.4.2 The limiting or special cases

In the liquidity trap case illustrated in Figure 3.7, the economy is initially at

point E0, the intersection of IS0 and LM0. Although both the goods and money

markets are in equilibrium, the income level of Y0 is below the full employment

income level YF. Reference to quadrant (d) reveals that this implies that

the level of employment (L0) is below its full employment level (LF) with real

wages (W/P)0 above their market-clearing level (W/P)1. At (W/P)0 the excess

supply of labour results in a fall in money wages (W), which reduces firms’

costs and causes a fall in prices. Although the fall in prices increases the real

value of the money supply (which shifts the LM curve outwards, from LM0 to

LM1), the increased real balances are entirely absorbed into idle or speculaThe

orthodox Keynesian school 117

Figure 3.7 The liquidity trap case

tive balances. In other words, in the liquidity trap where the demand for

money is perfectly elastic with respect to the rate of interest at r* (see also

Figure 3.1), the excess balances will not be channelled into the bond market

and this prevents a reduction in the rate of interest to r1 (at point E2) which

would be required to stimulate aggregate demand and restore full employment.

With no increase in aggregate demand to moderate the rate of fall in

prices, prices fall proportionately to the fall in money wages (a balanced

deflation) and real wages remain at (W/P)0, above their market-clearing level

(W/P)1. Aggregate demand is insufficient to achieve full employment and the

economy remains at less than full employment equilibrium with persistent

‘involuntary’ unemployment. Finally, as noted earlier, in section 3.3.3, in the

case of the liquidity trap monetary policy becomes impotent, while fiscal

policy becomes all-powerful, as a means of increasing aggregate demand and

therefore the level of output and employment.

In the interest-inelastic investment case illustrated in Figure 3.8, the economy

will also fail to self-equilibrate at full employment. As before, we assume the

economy is initially at point E0 (the intersection of IS0 and LM0) at an income

level (Y0) which is below its full employment level (YF). This implies that the

level of employment (L0) is below its full employment level, with real wages

(W/P)0 above their market-clearing level (W/P)2. The excess supply of labour

results in a fall in money wages and prices. Although the increase in real

balances (which shifts the LM curve from LM0 to LM1) through the Keynes

effect results in a reduction in the rate of interest, the fall in the rate of

interest is insufficient to restore full employment. Reference to Figure 3.8

reveals that, with investment expenditure being so interest-inelastic, full employment

equilibrium could only be restored through the Keynes effect with

a negative rate of interest at r1. In theory the economy would come to rest at

E1 (with a zero rate of interest), a point of underemployment equilibrium (Y1)

with persistent involuntary unemployment.

At this stage it would be useful to highlight the essential points of the above

analysis. In summary, reductions in money wages and prices will fail to restore

full employment unless they succeed in increasing aggregate demand via the

Keynes effect. In the liquidity trap and interest-inelastic investment cases,

aggregate demand is insufficient to achieve full employment and persistent

involuntary unemployment will only be eliminated if the level of aggregate

demand is increased by expansionary fiscal policy. The effect of combining the

comparative-static IS–LM model with the classical assumption of flexible prices

and money wages is to imply that Keynes failed to provide a robust ‘general

theory’ of underemployment equilibrium and that the possibility of underemployment

equilibrium rests on two highly limiting/special cases.

The above equilibrium analysis, which owes much to the work of

Modigliani, implies, as we have seen, that it is possible for the economy to

Figure 3.8 The interest-inelastic investment case

come to rest with persistent (involuntary) unemployment due to ‘rigidities’ in

the system, that is, rigid money wages, the liquidity trap or the interestinelastic

investment case. In contrast, Patinkin (1956) has argued that

unemployment is a disequilibrium phenomenon and can prevail even when

money wages and prices are perfectly flexible. To illustrate the argument,

assume an initial position of full employment and suppose that there then

occurs a reduction in aggregate demand. This reduction will result in a period

of disequilibrium in which both prices and money wages will tend to fall.

Patinkin assumes that money wages and prices will fall at the same rate: a

balanced deflation. In consequence the fall in the level of employment is not

associated with a rise in real wages but with the fall in the level of aggregate

‘effective’ demand. In other words, firms would be forced off their demand

curves for labour. In terms of panel (d) of Figure 3.8, this would entail a

movement from point A to B. Nevertheless, in Patinkin’s view this disequilibrium

will not last indefinitely because, as money wages and prices fall, there

will be a ‘direct’ effect stimulating an increase in aggregate demand, via the

value of money balances, thereby restoring full employment, that is, a movement

back from point B to A. This particular version of the wealth effect on

spending is referred to as a ‘real balance’ effect (see Dimand, 2002b). More

generally, as we discuss in the next section, the introduction of the wealth or

Pigou effect on expenditure into the analysis ensures that, in theory, as long

as money wages and prices are flexible, even in the two special cases noted

above the macroeconomy will self-equilibrate at full employment. We now

turn to discuss the nature and role of the Pigou effect with respect to the

possibility of underemployment equilibrium in the Keynesian IS–LM model.