The Keynesian Model
We now combine the AD theory of Section 5.4 with the Keynesian /15 theory of Section 5.7. The resulting system, which constitutes the Keynesian model, can be written as follows:
Here W is, as explained above, a predetermined variable. Furthermore, the policy variables M, g, and r are again set exogenously. Consequently, the system includes as endogenous variables justy, r, n, and P. The four equations (4), (9), (11), and (15") are then adequate in number to determine the values of the endogenous variables.
It will be noted that this system does not include the labor supply function (16')- The system has been written that way to emphasize the point that labor supply plays no role in determining the value of n.14 We can add (16') to the system, however, in which case it will determine the value of ns resulting from the real wage as determined in the main part of the system. Then ns can be compared with the value of n that prevails to determine something akin to an "unemployment" magnitude.
Graphically, the Keynesian model can be represented as in Figure 5-19. There it will be seen that there are two prominent differences from the classical model. First, as just mentioned, the labor supply function is not involved in the determination of n. Second, the AS curve is not vertical. That means, of course, that output is not determined solely in a subsystem (involving only production considerations) as it is in the classical model as presented above.15 In other words, the Keynesian model does not "dichotomize" (i.e., split into two segments).
14 That statement is true in our present static context, but would not be true in a dynamic version of the Keynesian model in which labor demand-supply imbalances affect future values of W.
15 Our version features one simplification—the absence of a "real-balance effect"— that is necessary for that property. A more properly specified classical model would not dichotomize (yet would feature monetary neutrality). On this subject, see Patinkin (1965).
To illustrate the workings of this model—and one of its most important properties—consider the effects of an increase in the stock of money. In Figure 5-20 we trace out the effects of an increase from M° to M1. It will readily be observed that the results are dramatically different from those of Figure 5-16, which examined the same policy action in the context of the classical model. In particular, the Keynesian model is one in which the neutrality of money does not obtain; an increase in M lowers r and raises n and y. Also, P rises by a smaller proportion than M, so M/P rises. The increase in n reflects a movement along the labor demand curve to a lower value of the real wage.
The fact that the classical and Keynesian models have such sharply different characteristics leads one naturally to wonder which of the two is better, that is, is more useful in understanding actual macroeconomic phenomena. As it happens, however, that question is not one that can be answered in a few sentences. Indeed, it is in a sense the central question of all macroeconomics. Consequently, we will not try to provide a brief answer here. Instead, we attempt to develop some appreciation of the merits and demerits of each of the two models—or, rather, extensions of these models—as the course proceeds.
- Figure 5-20
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