Abstract
We sketch a simple microfounded model that tries to capture the basic results of different macroeconomic schools by changing the values or behaviors of some parameter(s). The model has four different cases, which we label “Classical” (flexible prices and wages guaranteeing full employment), “Keynes’ Liquidity Trap” (a shortage of demand incapable of being corrected even with wage or price deflation), “Sticky-Price Keynesian,” and “Sticky-Wage Keynesian.” We associate each of these instances of our model with “textbook cases,” respectively: the labor-credit-money markets of the Classical case; Keynes–Krugman liquidity trap; the IS–LM model; and the AD–AS model.
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Notes
In the remainder of the paper we use the word “sticky” to mean “downwardly sticky,” that is, prices or wages that don’t fall in spite of an excess supply in the relevant market.
The absence of investment is not fatal to describe what happens in Period 1, which is the main concern of the model. Like a fall in consumption, a decrease in investment would reduce current demand with current productive capacity unchanged and thus require adjustment; but changes in investment would complicate the model further through second-round effects on future productive capacity and permanent income.
As in most textbook models, we assume an exogenous rather than a maximizing fiscal policy.
The first derivative of (1+α+β+αβ)/(1+sα(1+β)) with respect to β is positive: (1)/(1+sα(1+β))2, so (∂y1/∂β) < 0.
This non-linearity in costs allows us to derive a linear production function without an infinitely elastic labor demand curve, both of which make the solution easier. Is it realistic? If we added a fixed cost, the existence of a quadratic supervision cost would normally lead, in conditions of perfect competition, to a “realistic” number of firms, that is., more than 1 and less than infinite. The quadratic cost function, first introduced by Lau [1976], can be written as a Taylor expansion of second order [see Trujillo and Jara-Díaz 2003, pp 9]. Another possible interpretation of increasing marginal labor costs with linear productivity is the well-known wage-premium associated to firm size [Oi and Idson 1999], which could be due to an efficiency-wage argument. Others stories fit well: Garen [1985] argues that large firms face numerous information problems and the cost of acquiring information about personnel rises with firm size; these greater information costs seems to manifest themselves in increasing wages. Martínez-Budría et al. [2003] adapted productivity analysis to the case of a cost model using a quadratic cost function and discrete data (see also Bhattacharyya and Glover 1993).
In contrast to Barro, however, by assumption there is no labor supply effect through an increase in the interest rate, so “full employment production” is constant. Although labor supply effects are a central feature of macroeconomics fluctuations in the Classical tradition, they cannot be captured in this simple model.
Even though in Krugman’s original paper current prices are fixed, the same logic applies to this case. We recall the “Krugman scenario” with fixed prices in the IS–LM case.
In our model money demand becomes completely elastic at low rates so that not even an absolute zero interest rate is feasible. This feature is reminiscent of Keynes’ [1964] proposition that money and bonds become indifferent at slightly positive rates because bonds have a price risk but cash does not (Chapter 15). Contrary to our model, the experience of the mid 2010s shows that small negative interest rates may actually occur.
There is no Pigou effect at work here. Recall that the Pigou effect would mean that as the price level falls, real balances increase and thus private wealth grows. If there were a Pigou effect, in fact, a level of prices low enough to generate expenditures equivalent to full employment would exist. However, in this model money is purchased from the government and thus deflation doesn't add to real private wealth.
This is, of course, Keynes’s basic remedy to the liquidity trap in The General Theory. Correia et al. [2011] show that unconventional fiscal policy can replicate the effects of a negative nominal interest rate. Eggertsson [2011] considers the fiscal multiplier through the effect of spending on output.
For different rules of commitment and credibility see Eggertsson [2006] and Eggertsson and Woodford [2004].
Keynes [1964, p. 263]. Of course, because our model lacks investment only the reference to consumption applies here.
The exclusion of investment, at this point, could appear as hardly compatible with Keynes, who emphasized the variations in expectations and its impact on capital demand. Skidelsky [2011] among others believe that uncertainty is at the heart of “the relevance of Keynes”. However, a classical model could accommodate even the widest swings in expectations without falling into unemployment as long as there’s no liquidity trap and prices and wages are fully flexible.
During the 1920s wage stickiness had been central to his unemployment views and his take on Churchill’s return to gold at the pre-World War I parity.
Why? With a monetary target, an IS–LM also develops, but with some peculiar traits. An earlier draft of this paper including that case is available from the authors or at classicsandkeynesians.blogspot.com.
The liquidity trap formulation of Krugman [1998] is precisely this sub-case: a liquidity trap in the context of fixed prices. We keep them as separate cases to emphasize that they are two different potential obstacles to full employment.
As we will show shortly, a more traditional AS–AD develops by assuming a different monetary policy in Period 2.
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Acknowledgements
We are grateful to attendees at the Universidad Torcuato Di Tella Economics seminar. Guillermo Cruces, Martin Tetaz, Juan Carlos de Pablo, Emilio Espino, Andres Neumeyer, Juan Pablo Nicolini, Julio H. Olivera, and anonymous referee provided very useful comments that certainly improved the original version of this paper.
