Macroeconomics
MACROECONOMICS
AN INTRODUCTION TO
KEYNESIAN-NEOCLASSICAL CONTROVERSIES
Second Edition
Rosalind Levaci6
and
Alexander Rebmann
M
MACMILLAN
© Rosalind Leva~ic and Alexander Rebmann 1976, 1982
All rights reserved. No reproduction, copy or transmission
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Any person who does any unauthorised act in relation to
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civil claims for damages.
First edition 1976
R~printed 1977, 1978, 1979, 1980, 1982
Second edition 1982
Reprinted 1983, 1985, 1986
Published by
MACMILLAN EDUCATION LTD
Houndmills, Basingstoke, Hampshire RG21 2XS
and London
Companies and representatives
throughout the world
ISBN 978-0-333-34145-2 ISBN 978-1-349-86044-9 (eBook)
DOI 10.1007/978-1-349-86044-9
Für Sasha
WEST BEAST: EAST BEAST
Upon an island hard to reach,
the East Beast sits upon his beach.
Upon the west beach sits the West Beast.
Each beach beast thinks he's the best beast.
Which beast is best? ... Weil, I thought at first
that the East was best and the West was worst.
Then I looked again from the west to the east
and I liked the beast on the east beach least.
DR SEUSS (1979)
Contents
Preface XI1\.
List of Algebraic Symbols XV
INTRODUCTION TO MACROECONOMICS
1. 1 The development of macroeconomics 1
1.2 Some preliminaries 8
COMPARATIVE STATICS IN THE CLOSED ECONOMY
2 ONE-SECTOR NEOCLASSICAL AND KEYNESIAN MODELS 15
2.1 The quantity theory of money 15
2.2 The simple Keynesian model 18
2.3 Conc1usions 23
3 THE ISLM MODEL 25
3.1 The interaction of the real and monetary sec tors of the
economy 25
3.2 The ISLM model: the Keynesian version 27
3.3 The neoc1assical version of the ISLM model 38
3.4 Changing the exogenous variables 39
3.5 Comparative-static analysis: the Keynesian model 41
3.6 Comparative-static analysis: the neocIassical model 43
3.7 Conc1usion 44
4 FISCAL AND MONETARY POLiCY ANALYSIS IN AN ISLM MODEL 46
4.1 The ISLM model with the government sector 46
4.2 Policy analysis in a Keynesian model 49
4.3 Policy analysis in a neocIassical model 52
4.4 The role and relative efTectiveness of fiscal and monetary
policy 55
4.5 Extensions to the basic ISLM model 58
viii Contents
5 UNEMPLOYMENT AND THE LABOUR MARKET 61
5. 1 The demand for labour 61
5.2 The supply of labour 65
5.3 Neoclassieal labour-market equilibrium 67
5.4 Keynesian unemployment 70
5.5 Why did unemployment inerease in the 1970s? 76
6 THE THREE-SECTOR MACRO MODEL 81
6.1 The aggregate demand function 81
6.2 The neoclassical three-seetor model 82
6.3 The Keynesian three-sector model 86
6.4 The net wealth etTect of ehanges in the price level 93
6.5 Poliey implications of the neoclassical-Keynesian synthesis 97
11 MONEY AND THE OPEN ECONOMY
7 THE BALANCE OF PAYMENTS AND KEYNESIAN ANALYSIS 103
7.1 The exchange rate 104
7.2 The balance of payments 106
7.3 Absorption and the balance of payments 109
7.4 Keynesian approaches to the current account 111
7.5 Devaluation and real wage resistance 117
8 THE DEMAND FOR MONEY 125
8.1 The transactions demand for money 125
8.2 The demand for money as an asset 128
8.3 The effect of inflation on the demand for assets 133
8.4 The quantity theory approach to the demand for money 134
8.5 Empirical work on the demand for money 138
8.6 Conclusion on the stability of the demand for money 145
9 THE MONEY SUPPLY 147
9.1 Financial intermediation 147
9.2 A mechanistic model of bank deposit determination 148
9.3 A behavioural model of money supply determination 150
9.4 A demand-determined view of the money supply process 155
9.5 Methods of monetary control 156
9.6 Money supply determination in an open economy 160
9.7 Conclusions: controlling the money supply 162
10 MONEY, CAPITAL FLOWS AND THE OPEN ECONOMY 164
10.1 The Mundell-F1eming Keynesian model 165
10.2 Asset markets, expectations and exchange rates 174
10.3 Fixed versus flexible exchange rates 176
Contents ix
11 THE MONETARY APPROACH TO THE BALANCE OF PAYMENTS 180
11.1 Monetary analysis under a fixed exchange rate 183
11.2 Monetary analysis under a flexible exchange rate 188
11.3 Policy implications of the law of one price 192
11.4 Policy implications of a small open economy model 199
III TRADITIONAL DYNAMICS OF THE REAL SECTOR
12 CONSUMPTION 205
12.1 The definition of consumption 205
12.2 The absolute income hypothesis 207
12.3 Intertemporal choice 209
12.4 The permanent income hypothesis 212
12.5 The life-cycle hypothesis 218
12.6 Empirical evidence on aggregate consumption 221
12.7 Consumption theory: policy implications 225
12.8 The consumption function in macro models 226
13 INVESTMENT 229
13.1 Capital theory and the theory of the firm 230
13.2 Finance and the cost of capital 235
13.3 The accelerator theory of investment 240
13.4 The impact of inflation 242
13.5 Policy measures which afTect investment 243
13.6 Empirical evidence 244
13.7 Conclusion 246
14 THE TRADE CYCLE: KEYNESIAN AND MONETARIST INTERPRETATIONS 248
14.1 Keynesian trade-cYcle theory 250
14.2 The monetarist interpretation of trade cycles 257
14.3 Conclusion 260
15 ECONOMIC GROWTH 261
15.1 The impact of capital accumulation and population growth 262
15.2 The Harrod growth model 265
15.3 The Solow neoclassical model of economic growth 272
15.4 The impact of technical change on the neoclassical
growth model 279
15.5 Cambridge criticisms of the aggregate production function 281
15.6 Conclusions 282
IV CURRENT CONTROVERSIES IN MACROECONOMICS
16 wALRASIAN AND KEYNESIAN ADJUSTMENT MECHANISMS 291
16.1 Walrasian equilibrium 292
x Contents
16.2 Post-Keynesian economics 300
16.3 The reinterpretation of Keynes as non- Walrasian
equilibrium economics 303
17 NEO-KEYNESIAN QUANTITY-CONSTRAINED MODELS 310
17.1 A taxonomy of non-market-clearing states 311
17.2 A neo-Keynesian fixed-price quantity-constrained model 315
17.3 Quantity-constrained open-economy models 327
17.4 Rationalising wage and price inflexibility: implicit contracts 328
17.5 Policy implications in quantity-constrained models 331
18 THE PHILLIPS RELATION 338
18.1 The early Phillips curve 338
18.2 The natural rate of unemployment hypothesis 342
18.3 The 'new microeconomics' of the labour market 347
18.4 Adaptive expectations 350
18.5 Rational expectations 352
18.6 Empirical evidence 353
19 THE NEW CLASSICAL MACROECONOMICS 361
19.1 The new classical critique of Keynesian micro-
foundations 361
19.2 The new classical approach 363
19.3 Implications of the new classical macroeconomics 370
19.4 Criticisms of thel1ew classical approach 372
19.5 Empirical evidence 374
19.6 Conclusion 375
20 INFLATION 379
20.1 The monetarist approach to inflation in a closed economy 379
20.2 International monetarism 383
20.3 Structuralist theories of inflation 386
20.4 Empirical evidence on the determinants of inflation 389
20.5 The costs and benefits of inflation 395
20.6 Policies to reduce inflation 400
V ECONOMIC POLICY
21 POLICY ANALYSIS WHEN ASSET STOCKS ADJUST 407
21.1 The government budget constraint 407
21.2 The main policy issues 409
21.3 Policy analysis in a closed Keynesian economy 410
21.4 New Cambridge: a Keynesian open-economy model 415
21.5 Monetarist policy analysis in a closed economy 418
21.6 Conclusions 423
Contents XI
22 THE THEORY OF ECONOMIC POLICY 426
22.1 The traditional Keynesian case for activist policy 427
22.2 The case against activist policy: destabilisation 432
22.3 The new c1assical critique of activist policy 434
22.4 Policy-making 439
23 MACROECONOMIC THEORIES AND POLICIES: AN OVERVIEW 442
23.1 The theoretical basis of Keynesian economic policy 442
23.2 The monetarist--dassical critique of Keynesian economics 444
23.3 A final summary 445
Author Index 447
Subject Index 450
Preface
When I finaBy came to write a second edition of Macroeconomics I quickly
realised two related facts. Over the last six years macroeconomics, like Topsy,
had grown and the consensus in which I had been brought up had all too
clearly broken down. To deal with these developments I did two things -
recruited a co-author and completely restructured the book so that it uses the
Keynesian-neoclassical conflict as an expositional device from beginning to
end. This restructuring plus dealing with the new developments without over-
loading the book meant a complete rewrite. The second edition is really a new
book, hence its new sub-titie.
The 'new' Macroeconomics, to borrow a phrase much used by fellow
economists of aB persuasions, is divided into five sections. These are
deliberately arranged in order of difficulty. The first section, which covers the
Keynesian-neoclassical synthesis for a closed static economy and section 11 on
money and the open economy, together with Chapter 20 on inflation and the
last chapter, can on their own form the basis of an intermediate course on
macroeconomic theory and policy. Sections IV and V are more advanced and
deal with current theoretical controversies and the related policy issues.
We have found the Keynesian-neoclassical conflict a good framework for
organising the whole book. However, we use the Keynesian-neoclassical
distinction as a useful expositional device and not as two categories into which
aB economists can be neatly allocated. Individuals are often loath to put a label
on themselves for fear that ideas which they do not hold will be attributed to
them. Many individuals hold eclectic positions, taking ideas from the different
schools of thought.
The Keynesian-neoclassical distinction gives a central and recurrent theme
for the book. It enables us to emphasise that the differences in policy conc1u-
sions stern from different assumptions about how the economy works and that
the crucial distinction between Keynesian and neoc1assical macro theory
centres on different conceptions about how the supply of output responds to
changes in demand.
Since Keynesians believe that markets fail, whereas neoc1assicists hold that
markets work, the crucial difference in their specification of the aggregate
xm
xiv Preface
supply function folio ws quite obviously. However, until supply-side economics
became fashionable it was standard practice to emphasise the demand side and
related local skirmishes. One of the fascinating aspects of studying a subject for
many years is the dawning realisation that changes are not necessarily brought
about by new theories but by different ways oflooking at old theories. Nuances
and emphases are crucial, especially for minds coming to a subject fresh and
unformed.
Putting modesty aside there are several things we like about our textbook.
We hope that within the framework of the Keynesian-neocIassical conflict we
have developed an interesting exposition of current theory and policy so that
they are cIosely and naturally related to each other and to their broad historical
context. We fee! pretty strongly that any macroeconomics textbook which
relates to Britain or any non-US advanced mixed economy must deal with the
theory of a small open economy. This we have done, in three chapters in
section 11, and in sm aller sections in later chapters, incIuding a discussion of
the New Cambridge model in its proper context in Chapter 21.
Another strength of the book we feel is that it makes accessible to students
recent important work on neo-Keynesian non-market-cIearing models and on
new cIassical market-cIearing models with rational expectations.
W riting this book has been achallenging and enjoyable task but not one we
have the stamina to repeat, at least not for a few years. We have been greatly
assisted by friends and colleagues, in particular Jock Oliver and Laurence
Harris, who spared us their time to comment on our efforts. Macmillan's
anonymous reviewer also made an invaluable contribution to certain parts. We
thank them and acknowledge the usual responsibilities for errors, omissions
and lack of cIarity. However, without Moira Hilder we doubt whether there
would have been a typescript to read. If we had been forced to re1y on the
secretary who typed the first edition (Rosalind Levacic!) we could not have
faced the task of rewriting the book. So we would like to express our heart-felt
thanks to Moira for all her he!p. For once the author will not be thanking his
wife and children for their forbearance while he neglected them in the
furtherance of his academic output.
The Open University ROSALIND LEVACIC
Middlesex Polytechnic ALEXANDER REBMANN
July 1982
List of Algebraic Symbols
This list is not exhaustive: a few symbols used only briefly within a single
chapter are not listed here. Due to the limitations of the alphabet some letters
have been used to symbolise more than one variable, though never in the same
chapter. The chapters in which such a divergence from the most common use
of the letter in question are indicated.
A = absorption
AE = autonomous expenditure (eh. 14)
An = annual income on bond (eh. 3); annuity (eh. 12)
a = average cost of capital
B = number of government bonds issued, each paying .0 per year in
income (market value of firm's debt: eh. 13)
B D = domestic bonds held by domestic residents
B F = domestic bonds held by foreigners
B p = price of bonds (eh. 3)
BOF = balance for official financing on the balance of payments
b = marginal propensity to consume
C = consumption (currency holdings of non-bank public: eh. 9)
CA = current account of balance of payments
CAP = capital account of balance of payments
c = desired currency-bank deposit ratio
D = bank deposits (dividends: eh. 13)
D S = sight deposits
D T = time deposits
DC = domestic credit
E = aggregate demand
e = exchange rate defined as number of units of foreign currency
exchanging for one unit of domestic currency
e = cost of equity capital (eh. 13)
F = imports in terms of foreign currency (imports in terms of domestic
currency: eh. 21)
FR = foreign exchange reserves
J = marginal propensity to import
xv
XVI List 01 A 1gebraic Symbols
G = government expenditure
g = growth rate of some variable (growth rate of dividends: Ch. 13)
ge = expected growth rate of some variable
H = high-powered money (hours of work available: Ch. 5)
I = investment
i = real interest rate
i D = rate of interest paid on time deposits
if = foreign rate of interest
i L = interest rate on bank loans
K = capital stock
k = inverse of velocity (long-run MPC: Ch. 12)
L = labour units
L D = demand for labour
L s = supply of labour
L R = central bank lending rate
M = money stock
MD = demand for money stock
M S = supply of money
m = bank multiplier
N = firm's net cash flow (Ch. 13)
NW/P = real net wealth
P = price level
Pd = domestic price level
PI = foreign price level
pT = price of tradables
p N = price of non-tradables
PIP = inflation = 1t in Ch. 20
E(P)/P = expected rate of inflation = 1t e in Ch.20
pk = price of a unit of real capital
Q = labour productivity
QjQ = rate of change of labour productivity
Real rate of return on investment
q = Tobin's q = - - - - - - - - - - - - -
Cost of capital
R = cash reserves of banking system (Ch.9) (leisure hours: Ch.5)
r = nominal rate of interest (banks' reserve ratio: Ch.9)
S = savings (total market value of shares: Ch. 13; hours worked: Ch. 5)
s = marginal propensity to save
T = tax revenues or state of technology
t = tax rate
U = unemployment
UN = natural rate of unemployment
V = velocity of circulation of money (net present value of firm's net cash
flows: Ch. 13)
v = capital-output ratio
W = money wage rate (wealth: Ch. 12)
w = W/P = real wage rate
X = exports in terms of domestic currency
List of Algebraic Symbols xvii
Y = nominal national income
y = real income
yd = disposable income
yp = permanent income
llF = eJasticity of demand for imports
llx = elasticity of demand for exports
1t = profits (inflation: eh. 20)
p = marginal efficiency of capital
