The Modified Keynesian Model

Aggregate Supply

The Equilibrium Level of National Income

Collapse of the Keynesian Consensus


Supply Side Economics

New Classical School

Real Business Cycle Theory

In the preceding topic we studied the basic Keynesian model and saw how it was incorporated into a broad system of theory, the "neo-classical synthesis", and a widely accepted approach to economic and social policy known as "the Keynesian consensus".  How much of this would have been acceptable to Keynes is debatable and it has often been said that Keynes himself would never have become a "Keynesian" of the kind who came to dominate academic economics and public policy in the two decades following his death. 

Despite the "synthesis" and the "consensus", however, Keynesian macroeconomics was subject to ongoing criticism, some of it from academic economists who were uncomfortable with its theoretical foundations, and more of it from economists and others who did not like its political implications. By the 1970s, changing economic circumstances and a shift in political opinion, both common to most of the developed, industrial democracies, brought this criticism out into the open and a major attack was launched against the Keynesian orthodoxy. Particularly influential in this was the experience of unusually high (for "peacetime") rates of inflation conjoined with rising levels of unemployment. Once consequence of this was a significant restatement of Keynesian principles in a model designed to accommodate the possibility of changing price levels. This modified "Keynesian" macro model appears in some form or other in nearly all introductory texts in economics today. 

The Attack on the Neo-Classical Synthesis 

The great post-World War II "Keynesian consensus" and its intellectual underpinnings, the neo-classical synthesis, came under attack from both the left and the right during the turbulent decades of the 1960s and 1970s. The assault from the left took two forms. One, overtly ideological, was a surprising revival of interest in Marxism, particularly among disenchanted post-secondary students from affluent backgrounds. The radical critique levelled at mainstream economics, as represented by Samuelson’s synthesis, drew upon standard Marxist doctrine, albeit with some often elegant reinterpretations. In America Paul Baran and Paul Sweezy published Monopoly Capital (1966), which attracted the attention of many mainstream as well as radical economists. In Europe, Ernst Mandel’s Marxist Economic Theory (1968) dazzled the leftist intelligentsia by restating Marxist economic theory in modern terms and setting out the processes by which the decadent western industrial economies could find salvation in a Marxist solution to their problems.

The new Marxian challenge to the neo-classical synthesis was for the most part external to the whole system of orthodox economic doctrine, which was rejected by the Marxists in its entirety. But another challenge from the left came from within the mainstream of the economics profession itself. During the 1960s and 1970s a number of academic economists in Britain and the US reworked certain aspects of Keynesian macro-economics in ways which put them at odds with the majority who had embraced the new Hansen-Samuelson synthesis. 

Taking off from Keynes’ emphasis on the role of investment spending as the source of fluctuations in the level of aggregate demand, this new school of thought (usually called "neo-Ricardian" in the UK and "post-Keynesian" in the US) depicted modern industrial economies as being highly unstable because of the uncertainties surrounding investment decisions. Normal market mechanisms were seen to be of little consequence in determining how goods and services come to be produced and resources allocated to these activities. In their view, technical relationships among inputs and outputs were more important than the prices of inputs. So-called "market" prices were seen to be determined rather arbitrarily by the bargaining between organised workers and their employers, government regulation and other institutional forces. In Britain, these ideas were initially popularised by two younger Cambridge contemporaries and followers of Keynes, Piero Sraffa and Joan Robinson

The centrepiece of neo-Ricardian analysis relates to the theory of capital, perhaps the most troublesome of the conventionally identified factors of production. The original Marxian split with the classical economics of the early 19th century had also involved capital, which Marx insisted was not a separate factor input at all, but a kind of hybrid commodity in which labour was embodied to be applied to further production. Neo-classical economics, however, preserved the notion of capital as a distinct and separate factor of production, no small matter when it comes to discussing the legitimacy of its owners’ claims to a share of the resulting total output which it helps to create. But if capital (say a machine in a factory) is a separate productive entity, it must be possible to define and measure its value or worth. This is the seemingly esoteric point which Joan Robinson picked up on in a technically challenging paper published in 1953, "The Production Function and the Theory of Capital". In it she pointed to what every student of even the most elementary theory of market price is taught about how firms go about making their decisions as to how much of a good to produce. They try to maximise their profits or minimise their losses by finding the level of output at which their marginal costs equal their marginal revenues. This implies that they must know what their input costs are. They have to know what it costs them to employ a unit of labour, a unit of raw materials and, of course, a unit of capital. By definition, however, capital is a "produced good for use in further production". It is produced or acquired prior to being used to produce anything. If its price depends on the value it contributes to production (which will depend on the state of technical knowledge, which can change rapidly), how can its price be known to firms trying to decide whether they should use more or less of it? Worse, if the prices of the final products depend on the cost of the inputs employed to produce them, the reasoning involved in neo-classical production theory becomes circular—the price of inputs cannot be known until the price of outputs is known which cannot be known until the price of inputs is known ...

This seemed to make nonsense of a fundamental micro-economic component of the neo-classical synthesis and, not surprisingly, it provoked an immediate reply from Samuelson and others who had built standard neo-classical production theory into their eclectic system. There ensued an exchange of (highly technical) papers over the theory of capital, the war between the two Cambridges, as it came to be known (Cambridge in the UK and Cambridge, Massachusetts, home of the Massachusetts Institute of Technology where Samuelson was based). The outcome remains uncertain. Today many (most?) economic theorists concede that the Sraffa-Robinson side won on technical merit. When production depends heavily on inputs of capital goods (which yield a product over a considerable period of time) and the ultimate productivity of these inputs depends on the state of technology, the simple neo-classical theory of price as applied to ordinary goods markets in which produced goods are priced by the simultaneous interaction of supply and demand breaks down. Yet the standard elementary textbook treatment continues to treat this as a minor technicality, if it is mentioned at all, perhaps because some adherents to the Samuelson tradition find the policy implications of the post-Keynesian analysis of market price unacceptable. If prices and, consequently, the allocation of resources and the determination of factor incomes are not determined by the "normal" interaction of supply and demand in markets, the case for non-market intervention is strong.

The post-Keynesian criticism of the neo-classical synthesis carries these doubts about the micro-economy of market price into the macro territory as well. The modern economy is depicted as being dominated by the activities of organised interests interacting within an unstable environment of change and uncertainty in an effort to improve their own particular situations. Business organisations, labour organisations, large public and private agencies, advocacy groups of all kinds compete for power and influence over the outcomes of the economic process. Monopoly, oligopoly, monopsony, oligopsony, imperfect competition are the norm, while perfect competition is the exception. (When competition does break out, as happens in the agricultural sector, for example, it requires immediate treatment in the form of producer associations, agricultural price supports, and other measures to bring it under control.) The inference is clear: government must play an active role in keeping the system under control. As for the instruments of economic management, the post-Keynesian approach retains the Keynesian emphasis on fiscal policy, but rejects the compromise position built into the neo-classical synthesis with respect to monetary policy. Most post-Keynesians dismiss monetary policy altogether, arguing that the money supply has little if any effect on the level of economic activity. In fact, some follow the British economist, Nickolas Kaldor, in contending that the money supply is determined by the level of economic activity! Modern banking systems, in this view, supply the amount of credit required to carry out the transactions which firms and individuals wish to engage in -- and that is all.

The attack on the neo-classical synthesis from the right, like that from the left, had both an extreme ideological component and a more technically-oriented one. While the analogy is far from perfect, the right-wing equivalent of the Marxist critics on the left were those who sought to resuscitate classical economics and the spirit of individualism while the counterpart of the Sraffa-Robinson school were the "new classicals," who undertook to produce a new mathematical model of a self-regulating market economy which by implication would require a minimum role for government.

The ideological component of the conservative attack on the neo-classical synthesis had its roots in classical liberalism and later expressions of it in the work of such 19th century neo-classical writers as Karl Menger and other members of the "Austrian" school of economists. This tradition was carried into English-language economics by Friedrich von Hayek and Ludwig von Mises, both of whom preached the virtues of a minimum role for government and opposed socialism and other collectivist tendencies in 20th century thinking on the grounds that they were inimical to the preservation of freedom for the individual.

The subsequent development of what has come to be known as the "conservative counter-revolution" against Keynesianism and the neo-classical synthesis in which it became embedded derives from the work of Milton Friedman at the University of Chicago. Friedman’s approach to economics in turn owes much to the influence of two of his "Chicago School" predecessors, Henry C. Simons and Frank H. Knight. During the early 1930s, when so many economists were losing faith in the capitalist system, Simons, a contemporary and close friend of Knight, was working on a plan to rehabilitate it. In 1934 he published a paper, A Positive Program for Laissez-Faire, which recommended policy measures, including elimination of all monopoly, reform of the financial system, abolition of all tariffs, and restrictions on advertising "and other wasteful merchandising practices". Unlike most modern economists, Simons made no attempt to hide behind a curtain of scientific detachment from his subject matter. Right at the beginning of his paper he noted that it was "frankly a propagandist tract—a defence of the thesis that traditional liberalism offers, at once the best escape from the moral confusion of current political and economic thought and the best basis or rationale for a program of economic reconstruction." The idea was to restore competition and make it possible for the market system to function as had been envisioned by the classical economists. (Note that he was not opposed to the use of government to make this possible.) 

When Keynes’ General Theory appeared, Simons was appalled by its implications. If government was to assume responsibility for manipulating demand in the economy, Simons foresaw an intolerable centralisation of economic power. When Alvin Hansen took up the Keynesian cause, Simons attacked him, taking particular exception to Hansen’s suggestions that monetary policy could be used to supplement the fiscal measures emphasised in the original Keynesian model. The use of deliberate, discretionary policy by a central bank to manipulate the money supply and interest rates struck Simons as another intolerable concentration of economic power. In his view, what was needed was reform of the financial system to ensure that it operated within clearly defined rules which would apply to all the participants in the game, including the monetary authorities themselves.

Simon’s colleague at Chicago, Frank Knight, was primarily concerned with defending neo-classical market theory against the modifications being introduced by Pigou and others who were finding shortcomings in it. Internal inconsistencies arising from the problems of externalities, doubts about marginal productivity as the determinant of factor incomes and the like all arose because of an apparent disjunction of the theory and the reality it purported to explain. One of Knight’s important influences on the subsequent rehabilitation of neo-classical thought by his successors was his insistence that just because the theory was based on assumptions which abstracted from reality, this did not mean it was not useful. Theory could never do more than approximate reality. It was a device for understanding relationships in a simplified form. Without it, there could be no understanding at all. Criticising theory on the grounds that it abstracts from reality is to misunderstand the nature of theory altogether. Knight also recognised, however, that the simplifications required to make theory useful as a tool for understanding also imposes serious limitations upon its usefulness for predicting. 

The intellectual legacy of Knight and Simons was carried forward in the work of their student, Milton Friedman, whose name is now widely associated with economic conservatism thanks not only to his academic acclaim, but his activities as an advisor to governments, journalist, and star of a widely-viewed TV series, "Free to Choose". If, as is sometimes said, Simons was primarily interested in policy and Knight in theory, Friedman combines the interests and talents of the two. His professional and public career might also be compared to that of Samuelson in that both gained the highest respect of their professional colleagues while at the same time having an enormous impact on public opinion and policy. 

Much of the success enjoyed by Keynes and his followers in attacking neo-classical economics in the 1930s and 1940s derived from the apparent discordance between the established body of theory and observed fact. Friedman’s counterattack took advantage of a growing unease over the ability of governments to successfully apply "Keynesian" stabilisation policies in economies which were experiencing rising levels of unemployment while the general price level was also rising, a situation which the existing Keynesian models appeared unable to account for. 

Friedman launched his counterattack on Keynesian policy on several fronts, using both theoretical arguments, empirical evidence and his own formidable powers of persuasion. If the Depression of the 1930s had brought about the collapse of confidence in the idea of a self-regulating free-enterprise economy, paving the way for acceptance of the Keynesian macro-economic theory, it was appropriate for a critic of that policy to look at the experience which had given rise to it. This Friedman did with a vengeance. In 1963 he and a collaborator, Anna Schwartz, published a massive study, A Monetary History of the United States, 1867-1960. The main thrust of this work is to demonstrate that "money does matter". 

Throughout the period studied, Friedman and Schwartz found that there was a more or less direct relationship between monetary forces and the real functioning of the economy. Particular attention is paid in the study to the period leading up to the great collapse of the 1930s. At the risk of oversimplifying, they found that the Depression started off as a more or less normal contraction associated with a tightening of credit and reduction in the money supply. The cause of the subsequent disaster, however, was the failure of the central bank (the Federal Reserve System) to expand the money supply and prevent the financial panic which plunged the system into disorder and collapse. This analysis of the causes of the Great Depression remains controversial, but its lasting effect was to redirect attention to the possibility of a monetary, as opposed to an "insufficient demand" explanation of this critical episode in modern history.

In conjunction with his empirical work, Friedman developed, or redeveloped, a theoretical explanation of the relationship between money and the real economy. 

Freidman and his followers came to be known as "monetarists" because of their emphasis on the money supply as the active component of the economy which determined the level of real output and income. Just how this worked was described using an old relationship last popular in the 1920s, the so-called "equation of exchange". It stated that MV=PT. If the total money supply (M) was multiplied by the frequency with which it turned over or changed hands (V for velocity of circulation), the total would be equal to the general price level (P) multiplied by the number of real transactions (T) which corresponded to the output of real goods and services during some accounting period of time. 

If, as the monetarists were inclined to believe, the velocity of circulation (V) was stable in the short run, then changes in the supply of money (M) would have a predictable impact on the right-hand side of the relation. If the economy was operating at full employment, which they also tended to assume it would, then the level of physical output in the short run would be constant and any increase in M would consequently cause a corresponding increase in the price level. And any decrease in M would cause the general level of prices to fall. The implication was that changes in the money value of the national output would be due to changes in the supply of money. In the 1930s, they argued, the fall in the value of MV was caused by the failure of the monetary authorities to maintain the money supply at the appropriate level, not to a deficiency of aggregate demand or anything else.

Thus, for Friedman, depressions were the consequence of a temporary shortage of money and this implied that monetary policy was of prime importance in determining the aggregate level of output and employment, not fiscal policy as Keynes and his followers had mistakenly come to believe. All that government spending could do in such situations was make a bad situation worse, creating government debt which subsequently had to be funded through an increase in the money supply once the recovery came about, but then causing inflation. 

If Friedman was correct in concluding from his empirical and theoretical investigations that money and, consequently, monetary policy were the key to understanding what governs the level of economic activity in a free market economy, did it follow that monetary policy, effected through the operations of central banks, should be used to stabilize the system? Here we encounter Friedman, the classical liberal. The very potency of monetary management makes it dangerous. Like any other attempt to manage the economy, however well intentioned, such intervention will be ineffectual at best, or counterproductive at worst. There are many reasons for this. One of the more obvious is time lags. By the time the authorities have identified a problem, decided what action to take, and implemented that action, the condition which was supposed to be treated has been superseded by a different condition, often one requiring exactly the opposite action, but by the time the action is reversed, the situation will have been made worse, not better. These lags may be unavoidable because of the practical difficulties in collecting information and making political decisions. But they may also be aggravated by the political problems making sudden changes in policy give rise to. Politicians may be reluctant to endorse such changes if they imply that an error was made in taking action in the first place. But does this suggest that nothing should be done to manage the money supply? No, Friedman proposed that because the money supply must be increased as the economy grows, the monetary authorities should be required to pursue a policy of expanding the money supply at some fixed annual rate, regardless of current conditions. Long term historical analysis suggested a figure of about 5% as being appropriate, although Friedman subsequently apparently came to believe this was much too high. What he deemed most important was that some such rate be fixed and that the monetary authorities should be held to it. 

Another central component of Friedman’s criticism of the Keynesian approach related to the relationship between unemployment and inflation, the great paradox of the 1970s when the rates of both were increasing. Here Friedman became associated with the notion that in every economy there is a "natural rate of unemployment" which results from mismatches between job openings and applications due to problems of communication, changes in the structure of industry with some industries contracting while others expand, changes in the age and sex composition of the labour force and other institutional factors which may change over time and which will be different in different economies. Any attempt to reduce unemployment below this "natural" rate through the use of either fiscal or monetary policy, Friedman predicted, would be inflationary. This was not a particularly contentious assertion, but Friedman went on to argue that any such inflationary impetus would become self-sustaining, that the inflation would be an accelerating one. The reason for this lies in the way individuals form expectations about the future. The fact that economic behaviour is affected by guesses people make about the future has long been accepted by economic theorists of all persuasions. But until the 1970s it was customary to assume that people form their expectations on the basis of recent experience, that they tend to make rather simple linear projections of recent trends. Friedman’s work suggested that people were in fact smarter than this, although the full implications of this were not to become clear until the concept of "rational expectations" was spelled out in highly technical papers by Robert Lucas and Thomas Sargent and incorporated into Friedman’s analysis.

While it is difficult to express the reasoning simply without trivialising it, the rational expectations hypothesis holds that individuals make use of all the information they have access to in forming expectations. They use not only what they know of recent prices, for example, but also their knowledge of what the outcomes of their past attempts to foresee the future have been. If they have made mistakes, for example if they expected a certain rate of inflation to prevail and then the monetary authorities did something which prevented this expectation from being fulfilled, they will incorporate this knowledge in forming new expectations. This may entail formulating a theory of how the authorities behave. As a result, those who are supposed to be affected by policy learn how to anticipate it and adapt their behaviour accordingly. This renders policy ineffectual, which is what Friedman had contended all along.

In the case of macro-economic stabilisation policy this new approach seemed to predict outcomes which were all too evident in the real world of the 1970s. Why were attempts to reduce unemployment by boosting aggregate demand through expansionary fiscal and monetary policies apparently having more impact on the price level, raising the inflation rate, and little or no effect on the unemployment rate—the opposite of what the Keynesian model predicted? The explanation suggested by the rational expectations-enhanced Friedman model went something as follows: In the Keynesian model, workers decide whether to accept employment or not on the basis of the money wage they are offered. If fiscal and monetary policies are used to stimulate the economy they will, according to the Friedman approach, cause a rise in prices. When prices rise, firms have increased earnings and are willing to hire more workers. Do they have to raise wages? Not if workers fail to notice that the prices they have to pay for things have gone up. If workers are subject to such "money illusion", meaning that they offer their services on the basis of money wage rates, not real wage rates (money wages adjusted for the cost of living), expansionary measures of the kind advocated by the Keynesians could indeed result in an increase in employment, thanks to the fact that real wages are reduced, which makes firms willing to hire more workers. But if workers are wise to all this, when they negotiate wages with their employers they will not only insist on money wage increases that will compensate for price level increases in the recent past, but they will also want increases which will cover anticipated inflation during the life of their contract. Such wage demands in excess of current inflation rates add to the inflationary pressures initiated by government attempts to raise employment and the inflation spirals. And, of course, if workers are successful in getting the money wage increases needed to meet their expectations, real wages do not fall and, consequently, there is no increase in employment.

This line of reasoning carries the conservative case against government involvement in the economy farther than even Friedman apparently felt comfortable with, driving the position back not just to the late 19th century neo-classical position, but to an extreme interpretation of the classical economics of Adam Smith. As a result, the Monetarists, as Friedman and his followers came to be known, have been upstaged as representatives of the conservative right in economic doctrine by the "New Classicals" whose position, as we will see shortly,  buttressed by the rational expectations hypothesis, implies a very limited economic role for government indeed.

These concerted attacks on the standard Keynesian theory as it had developed to the 1970s failed, however, to dislodge Keynesian macroeconomics from the standard textbook treatments of the subject. But they did produce a substantial modification of it. 

Our modern expedient, which has become very general, is to mortgage the public revenues, and to trust that posterity will pay off the incumbrances contracted by their ancestors.

—David Hume 


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The Modified Keynesian Model

The basic Keynesian model identifies a relationship between total (planned) spending in the economy and the level of total income it will generate. As presented above, there is no explicit reference to the price level (although this was mentioned in the introductory discussion of how micro and macro views of the economy differ). The simple expenditure version of the Keynesian system explains how the equilibrium level of (real) GDP is determined by the relationship between total planned spending and the level of current GDP assuming some given level of all prices. If there is less planned spending than the current level of GDP the latter will fall. If there is more it will rise. When the two are equal the economy is in equilibrium. This equilibrium may or may not be full-employment level of total income.

In order to incorporate the possibility of changes in the general price level into the attainment of macro-economic equilibrium, it is necessary to drag out of concealment two concepts which are lurking in the background of the simple expenditure model, aggregate demand and aggregate supply. The former, aggregate demand, is the relationship between the general level of all prices and the amount of real output which will be demanded. The latter, aggregate supply, is the relationship between the general level of all prices and the quantity of real output which will be supplied.

Through the period from the end of World War II into the 1970s the fixed price level assumption implicit in the standard textbook treatments of Keynesian macroeconomics was not too difficult to accept. But as inflationary pressures built up in many of the industrial economies, it became necessary to modify the standard analysis to adapt it to changing circumstances. The modified Keynesian macro models came to incorporate explicit treatments of both aggregate demand and aggregate supply.

Aggregate demand in these models posits an inverse relationship between the quantity of real output demanded and the general level of all prices. (This is, of course, misleadingly the same as the relationship between particular prices and quantities demanded in micro-economic price theory.) 

Why would the quantity of real output demanded rise when the price level falls or vice versa? It cannot be because at lower price levels real output is substituted for other goods or services as in the case of individual market demands, because all goods and services are included in the total of real GDP. There is, however, another "good" which does remain an alternative — and that is money itself. One way of explaining the relationship involved is to reason that the lower the price level the more any particular amount of money is worth in terms of its purchasing power. If all prices suddenly fell by 50 per cent, everyone holding money would find that it had doubled in value. The lower the price level the higher the value of money in real terms. Real goods and services which comprise real GDP may consequently be thought of as being interchangeable with money (and other financial assets) and vice versa.

Changes in the general level of all prices consequently change the alternative opportunity cost of holding real goods or money. If the level of prices suddenly drops by 50 per cent, everyone holding money has now twice the real purchasing power they had before prices fell. They are, in a sense, twice as wealthy (in terms of their money holdings) as they were. Under these circumstances, the expected behavioural response would be for individuals and households to revise their spending plans. If everyone is affected at the same time, as would be case if there is a change in the general price level, the simultaneous rise in the real value of money holdings would result in an overall increase in the quantity of goods and services demanded in the economy as a whole. 

Conversely, if everyone holding money suffered the loss of half its value, because all prices suddenly doubled for example, the most likely response would be a general downward revision in spending plans. Individuals and households would seek to restore their money holdings, which would mean reducing their demand for goods and services. This response to changes in the general price level is called the real balance effect because the real value of the stocks of money and other financial assets held (the purchasing power of money and other financial assets) changes as a result of changes in the general price level.

Again, suppose the price level falls. A dollar will now buy more, but this also means that it has become relatively more expensive to hold that dollar as money rather than to exchange for goods. The demand for money, therefore, will fall and the demand for all other goods and services will rise. A rise in the overall price level has just the opposite effect. Given the total stock of money available, a rise in the price level means that goods and services have become relatively more expensive than money. Money has become relatively cheap and consequently money is substituted for goods and aggregate demand falls.

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Aggregate Supply

Aggregate supply refers to the total amount of goods and services firms will be willing to produce at various levels of overall prices. For reasons familiar from the study of the theory of the firm, as firms increase output they will experience rising costs (recall the principle of diminishing marginal physical productivity and how it affects the costs of firms in the short run, which is what we are concerned with here. Consequently, even if the prices firms had to pay for the services of factors of production were constant, firms would be willing to employ additional units of factor inputs and so expand their output only if the level of prices for their products was higher. The relationship between total supply, then, and the general level of prices is a positive one—the higher the price level, the larger the supply of goods and services produced and vice versa. There is also reason to believe that this becomes increasingly so as the level of output in the economy expands. As capacity output levels are approached, it may take larger and larger increases in the general level of all prices to induce firms to make further increases in their output.

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The Equilibrium Level of National Income

Combining aggregate supply and aggregate demand produces various combinations of price level and real GDP levels. One of these possible combinations will yield an equilibrium relationship between the two. At this equilibrium, aggregate supply and aggregate demand are equal and this level of prices and real output will remain stable until something disturbs one or both of the demand and supply relationships. 

Accepting the original Keynesian view that the price level is fixed, then all that matters is aggregate demand. If the quantity of total output demanded is greater at some given price level, real output and employment will be greater, and vice versa. If the extreme Keynesian position is modified and it is more realistically conceded that at higher levels of real output (as capacity utilisation is approached) the price level may be higher than at lower levels of real output, then shifts in aggregate demand will be associated with changes in both the level of real output (and associated employment) and in the general level of all prices.

What is happening is this case is that competition of producers for additional inputs (such as labour) needed to satisfy the rising demand for their output exerts an upward pressure on the prices of these inputs, although in the Keynesian model this is not expected to be a very strong effect. Once full capacity is reached, however, short run aggregate supply cannot increase and, as in the classical model, any increase in aggregate demand causes only a rise in the general price level. No increase in real GDP is possible beyond this point, at least in the short run. 

Is the equilibrium at which aggregate supply and aggregate demand are equal necessarily a desirable equilibrium? The answer depends on whether the equilibrium level of GDP is equal to, greater than or less than long run aggregate supply (full capacity, full employment real output). If the equilibrium is established at a level below what the economy could sustain in the long run, resources are being under-utilised and it would be desirable to increase aggregate demand. Keynesians are inclined to the view that this is the kind of equilibrium which developed industrial economies tend to fall into. On the other hand, if the equilibrium depicted is one at which the productive capacity of the system is being strained, it may be undesirable because of the inflationary pressures which will be generated. 

Collapse of the Keynesian Consensus

The modifiction of the Keynesian model to accommodate the possibility of significant price level fluctuations and the other changes associated with bringing aggregate supply and demand explicitly back into the analysis went far to preserve much of the standard textbook treatment of macroeconomics in the latter decades of the 20th century. But the broader consensus which had grown up around Keynsianism was clearly breaking down. 

Supply Side Economics

Especially in the US, some economists joined the attack on the Keynesian consensus by arguing that the major shocks disrupting modern industrial economies didn't involve aggregate demand shifts so much as aggregate supply shifts. Most traditional macro theory had tended to take aggregate supply as given, subject to change mainly in the long run (which will be the subject of a later lecture) and consequently not of immediate concern when studying short-term fluctuations. The supply siders argued that events such as the oil price shocks of the 1970s proved otherwise. 

As we have just seen, such possibilities could be accommodated in the mainstream aggregate demand/aggregate supply model supported by many new Keynesians, but the supply siders also usually went on to argue that government interventions in the form of taxes, regulations, income transfers and the like, which most mainstream economists accepted the need for, were also causes of poor macro economic performance because they raised costs of production, discouraged productive investment, and discouraged innovation and growth. 

Much of the supply side and monetarist influence on modern macroeconomic thinking has been eclipsed by the emergence of a body of thought known as New Classical Economics. While it is completely at odds with the Keynesian theory of the 1930s and 1940s, as a body of thought it bears some remarkable similarities in that, especially in its earliest forms, it's assertions seemed outrageous in contrast to the orthodox thinking of the day, it was couched in highly technical, mathematical language, and it has generated a mass of new research and theoretical debate.

The New Classical School

The new classical theory referred to earlier in connection with the monetarist school reasserted the classical belief in the self-adjusting properties of a market economy and argued that such systems tend to establish equilibrium at the full employment, capacity output, level. Temporary deviations occur, but are rapidly dealt with through free market interactions, because prices are fully flexible both upward and downward surpluses and shortages are quickly eliminated. This is even true of labour markets. If workers complain, for example, that they can't find work, it is because they are holding out for higher money incomes than the market can reconcile with the value they can produce. 

A distinguishing feature of the new classical analysis is its assertion that the effectiveness of markets is attributable to the skills people acquire in accurately forecasting outcomes based on experience, the concept known as "rational expectations".

The theory of rational expectations was given prominence by an American economist, Robert Lucas, who developed an elaborate reconstruction of the logic of a self-regulating free market economy in which individual buyers and sellers behaved not only rationally, but in such a way as to reflect their accmulated knowledge of how the economy worked and how it would affect their particular interests. Given the assumption that decision makers make use of all the information available to them, it followed that discretionary policy of the kind Keynesians had advocated would simply prove ineffectual. Learning from experience, those whose behaviour such policies were expected to affect, would simply find ways around them by altering their behaviour in whatever way they had to. 

Many aspects of rational expectations theory have now become well established in mainstream economic thinking about macroeconomics and are taken seriously even by economists who are unable to follow Lucas and the "new classicals" into believing that economic life can be, as their classical predecessors believed, completely self regulating through the normal functioning of markets.

Real Business Cycle Theory

Another outgrowth of this rational expectations analysis and the increasing attention being paid to the supply side of the economy is an influential but still controversial theory that explains macroeconomic instability in terms of random changes in technology, wars or other events which subject the economy to major shocks affecting productivity and output.
It's called "real" business cycle theory because it treats money as a passive element in the system which exerts no causal influences on how it behaves. 

Surges in technological change, according to this theory may cause business activity, investment and the demand for labour to rise, but they may also on occasion cause productivity to decline, setting off a downward spiral in business activity. This paradoxical result is blamed on the initial impact new technology may have on existing real capital, which it renders obsolete, or on human skills and other forms of "human capital" which temporarily becomes less productive than it was formerly, leading to job losses and business failures -- in other words, to a recession.

Interestingly, the real business cycle theorists go on to argue that one of the effects of such a downturn is to reduce the demand for money, leading to falling interest rates, and a contraction of credit by the banking system. In other words, the money supply contracts in a recession as a result of the decline in business activity, just the opposite of the monetarist assertion that it is the decline in the money supply that triggers such recessions!

The various alternatives to the Keynesian system just surveyed have all influenced present-day macroeconomics, but no single "school" has emerged to dominate the field. The modified Keynesian model continues to influence policy makers, as we will see in the next topic, although little is heard of Keynes and his ideas in graduate schools of economics these days. What continues to divide economists on the issues is the extent to which they can accept the concept of a self-regulating market system in which markets perform as the microeconomics text books show they might. Keynesians of varying stripes remain unconvinced while monetarists, new classicals, supply siders, and others argue with varying degrees of conviction that markets are functional and that the economy will tend automatically to find an equilibrium at some level of output consistent with a "natural" rate of unemployment without the help of well-intentioned policy makers. 

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