Keynes and Monetary Economics*
— Illuminated
through Wicksell’s Influences,
Keynesian
Revolution, and the Microfoundations
Toshiaki
Hirai (Sophia Univ.)
I. Introduction
To date, many historians of economic theory
have put their minds to the questions of: (i) how monetary economics developed in the inter-war
period; (ii) how Keynes developed his theory as monetary economics; and (iii)
how the theoretical relation between Wicksell and Keynes should be understood.
It is these questions that we, too, wish to address in this paper, which
runs as follows.
Firstly, having outlined Wicksell’s view of the state of economics, we
will examine his theory of cumulative process in Interest and Prices (Wicksell, 1898. Hereafter IP) (Section II). Secondly we will
take the economics of Myrdal and Hayek as the representatives under Wicksell’s influences.
We will see how they took a critical stance on the neoclassical orthodoxy, and look
into the type of monetary economics they constructed (Section III). In going so
far as to elucidate three scholars’ models, we mean to put them on a fair footing
in relation to Keynes.
It should be emphasized that the scholars (apart
from Wicksell1) who are to be taken up here have in common the fact that
they endeavored to construct their own brand of monetary economics: Myrdal and
Hayek under Wicksell’s influences; Keynes, first under the influence of, and subsequently
independently of, Wicksell; and Negishi under the influences of the
Disequilibrium Approach. They are critical of neoclassical orthodoxy which takes
the classical dichotomy and Say’s Law for granted.
It should also be noted that monetary economics as referred to here
is defined as a type of economics which , by constructing a consistent model, analyzes
how money influences output and employment. If a model does not meet this
criterion, it is not regarded as monetary economics.
II. Wicksell
1. His View of the State of Economics
With
respect to theory of relative prices, Wicksell in Value, Capital and Rent (Wicksell, 1893; hereafter VCR) regards Walras’ general equilibrium
theory (hereafter GET) as accurately describing the system of exchange and distribution.3
As for theory of absolute prices, in IP Wicksell criticizes the quantity theory on three points.
(i) It assumes
constancy in the velocity of money.
(ii) It
assumes that the medium of exchange consists of notes and coins only, so that
the quantity of money is inelastic if the quantity of currency remains constant.
(iii) It argues
that an increase in the quantity of money induces an increase in prices and a
fall in the money rate of interest.7
He then puts forward the theory of cumulative process as an
alternative to the quantity theory.8
2. The Theory of Cumulative Process
Wicksell’s theory of cumulative process9
explains changes in prices in terms of the relation between the natural rate and
the money rate of interest. The quantity of money is assumed to adjust to
changes in prices and trade.10
The natural rate of interest is defined as ‘the rate of interest
which would be determined by supply and demand if no use were made of money and
all lending were effected in the form of real capital goods’ (IP, p. 102). It is considered to fluctuate
incessantly due to technical progress, and comes within theory of relative
prices.
Suppose
that in an ‘organized credit economy’ in which ‘all domestic payments are
effected by means of the Giro system and bookkeeping transfers’ (IP, p. 70)11 the market rate
of interest is kept lower than the natural rate for a certain period of time. Expecting
profits, the entrepreneurs will borrow money as a ‘wage-rent’ fund12
from the banking system, and advance it to laborers and landlords. They, in
turn, purchase consumption goods from the capitalist dealers by spending their (advanced)
income. The capitalist dealers will earn interest by depositing the sale
proceeds in the banking system. The entrepreneurs engaged in current production
will sell their output to the capitalist dealers, and repay borrowed money with
the interest to the banking system. As a result, the entrepreneurs will earn
excess profits equal to [the natural rate - the market rate] × wage-rent fund.13
If the
entrepreneurs are able to go on making excess profits, their desire to expand
production will grow, and the demand for labor, raw materials and durable
investment goods will increase (no actual expansion will, however, occur, for the
structure of roundabout production is assumed to remain constant and full
employment is assumed14). This will lead to rises in money wages and
rent. The entrepreneurs need to borrow more money from the banking system. This
will be advanced to laborers and landlords, and the same process as the above will
proceed.
Once the entrepreneurs come round to doing their business taking rising
prices into account, prices will rise at an accelerated pace due to the ‘law of
continuity and inertia’ (IP, p. 135).
Eventually this process will come to an end as the market rate catches up with the
natural rate of interest, with the price stability at a new equilibrium.
At
the root of the theory of cumulative process there lies the determination of
the price level of consumption goods by aggregate supply and demand. Aggregate
supply is assumed to remain constant while aggregate demand depends on the
entrepreneurs’ willingness to expand production.15
III. Wicksell’s Influences —Myrdal and Hayek
We define Wicksell’s Influences16
as the economics of the inter-war period that saw the endeavor on the part of
the economists to construct each his/her own monetary economics, under the influence
of Wicksell’s theory of cumulative process. They include the economics of Mises,
Hayek, Myrdal, Lindahl, Ohlin, Keynes and so forth.17 The limited space here forces us to examine only two (Keynes will be
seen later).
1. Myrdal
A. His View of the State of Economics
Myrdal noted in Monetary Equilibrium (1939. Hereafter ME) the then growing dissatisfaction over the lack of internal
integration between price theory and monetary theory in the neoclassical
orthodoxy.18 How did such a sharp line come to be drawn between the two?
As he saw it, acceptance of the marginal utility theory resulted in money coming
to be regarded as merely representing the power of purchasing goods and
services.
He argues
that closer integration of the quantity theory with the central price theory is
logically impossible, for they are based on different principles.19
The quantity theory, he argues, has serious defects.20
(i) During a
dynamic process the velocity of money varies; the quantity theory cannot deal
with this.
(ii) The
relation between the quantity of money and the price level cannot be one-way.
(iii) The
price level cannot be defined in the form of providing the multiplicative
factor required by the central price theory.
(iv) The quantity
theory ignores change within the price level.
(v) The price
level in that context is a curious concept including the prices of pecuniary
rights.
(vi) The quantity
theory betrays the practical possibility by adopting the total sales as a
weighting principle of the price index.
Myrdal goes on to criticize the central price theory.21
(i) In failing
to obtain the multiplicative factors, it remains abstract and unreal.
(ii) As it
has prices only relating to a single point in time, it cannot deal with time
contracts. Thus the credit problem is relegated to the quantity theory, which in
turn proves unfit for the task.
(iii) Because
it embodies Say’s Law, it cannot analyze business cycles.
Myrdal concludes that neoclassical orthodoxy characterized by the
separation of monetary theory from the price theory cannot deal with the credit
problem; hence his new theory.
B. The Theory of Cumulative Process
a. Monetary Equilibrium
Myrdal constructs his monetary economics through
careful examination of Wicksell’s three conditions for ‘monetary equilibrium’:
(i) equality between the market rate and the natural rate of interest; (ii) equality
between investment and saving; and (iii) price level stability.
(1) What matters to monetary equilibrium is condition (ii ).
(2) Condition
(i) does not hold good, although the argument based on condition (i) contains an
investment function required in the theory of cumulative process .
(3) Condition (iii) does not hold good.
Myrdal formulates monetary equilibrium as:
R2 = W = S + D (1)
R2, which is the discounted present
value of investment cots anticipated at the initial point of time, is the money
demand for new investment.
Savings proper (hereafter savings) are defined as the part of income not
used for consumption.22
S = Y - C (2)
Income, which is synonymous with “net returns”, is an ex-ante concept
defined as:
Y = B - (M + D) (3)
b. Cumulative Process
Now suppose that the economy starts off in
monetary equilibrium.
The
investment function works as the driving force. The entrepreneurs as a whole
determine the amount of investment based on the profit margin.
R2 = F (Q) (4)
Q
is given by:
Q = Σ w (c1′
- r1′)
(5)23
Myrdal assumes that the value of capital fluctuates violently while the
reproduction cost does not because it includes various kinds of inflexible
prices such as wages.
Let us now turn to consumption goods. Here we find two kinds of
argument.
The first has to do with determination of
the price level of consumption goods.
Y - S = P1. O (6)
The
left-hand side is the demand for consumption goods. The volume of production is
determined ex-post by the roundabout production structure.
Equations (2) - (6) complete the system.24 This holds good in
each period.
The entrepreneurs determine the amount of gross investment based on
the profit margin (equation (4)). The amount of gross investment is realized in
accordance with ‘freie Valuta’ (IP,
p. 109), and the amount thus realized is injected into
the stage of intermediate goods production. It should be noted that gross
investment and free capital disposal are not equal, for they are determined by
different economic agents. They are ex-post equal.
In equation (6), the demand for consumption goods ascertained through
equation (2) determines the price level together with the volume of production
ascertained through the roundabout production mechanism.
The second argument centers on the idea that a rise (fall) in the price level of
consumption goods induces, through its effect on expectations, a rise (fall) in
the value of the existing real capital, C1, in the next period:
ΔC1 = Φ (ΔP1) (8)
This influences the profit margin through equation (5). Myrdal’s model
is thus completed as a dynamic system.
Based
on the above system, Myrdal explains the cumulative process in three cases in
which a change occurs in: (i) anticipations; (ii) the money rate of interest;
(iii) savings. What is explained is the situation in which divergence between investment
and free capital disposal is cumulatively expanding, due to the change.
2. Hayek
A. His View of the State of Economics
Hayek in Prices and Production (Hayek, 1931) classifies the development of
monetary theory in four stages, emphasizing the need to attain the fourth
stage. Hayek criticizes the quantity theory as the first stage from a point of
view of methodological individualism, arguing that aggregate concepts can have
no influence on the decision-making of individuals, and that even when the quantity
theory discusses the influences of prices upon production, it does so only in
terms of the general price level and total production.
Hayek is also dissatisfied with the neoclassical system per se , remarking
that monetary theory is, by virtue of the quantity theory, detached from
general economic theory25 as a theory of relative prices.
B. The Theory of Business Cycle
Hayek advocates monetary economics that can
analyze the process in which a change in the quantity of money influences, through
a change in relative prices, the structure of roundabout production.
He builds
his theory of business cycle on Wicksell’s theory of cumulative process, correcting
its defects along the line taken by Mises (1912).26
In his theory
the theory of relative prices and roundabout production, to be shown
below, plays an important role.
People
spend their money income on consumer goods or various kinds of producer goods, and
the relative prices of these goods will accordingly change . Thus there will occur
a change in the price margin between successive stages of production. Producer
goods, consisting of non-specific and specific goods, will then be shifted so
as to be used in the higher (lower) stages of production, and the structure of
roundabout production will become longer (shorter), which will increase
(decrease) the volume of output of consumer goods.27
Hayek’s theory of business cycle combines the above with the monetary
phenomenon. He explains it, distinguishing the cases of ‘voluntary saving’
and ‘forced saving’. The demarcation lies in whether the quantity and
velocity of money remain constant and do not influence the real economy. The
former case describes the normal state of the economy which the monetary
authority should aim at, while the latter shows a departure from it and
prolonged disequilibrium.
Let us see what will happen in the case of forced saving.
Hayek addresses the following question: when additional money is
injected into the economy which is in a state of equilibrium, how will normal
prices be disturbed and how will the structure of production be affected?
He distinguishes two cases according to the new money (credit) being
provided to (i) producers, who desire to obtain producer goods; or (ii) consumers,
who want to buy consumer goods.
In
case (i) investment (the demand for producer goods) is equal to the sum of
voluntary saving and new credit, while in case (ii) investment is equal to
voluntary saving. In either case, the amount of money increases and results in the
money rate falling below the natural rate of interest. Let us begin with case
(i), because case (ii) will appear after case (i) has been gone through.
The
would-be entrepreneurs provided with credit can now purchase producer
goods, but only if they offer prices higher
than those offered by the existing entrepreneurs. Due to the fall in the money rate of interest, together with a rise
in the prices of the original means of production, and a rise in the prices of
non-specific producer goods, the existing entrepreneurs will find it reasonable
to reduce expenditure on the original means of production and non-specific
producer goods, and to increase expenditure on intermediate products (capital).
Thus the new entrepreneurs, by obtaining the necessary original means of
production and non-specific producer goods, can generate a new roundabout stage
of production, and the structure of roundabout production will thereby grow
longer.
The
volume of output at the stage of production from which the original means of
production and non-specific producer goods were withdrawn will decrease, and
consequently, when it eventually matures as consumer goods, the volume of
output of consumer goods will decrease. This is ‘forced saving’ in Hayek’s
sense.
Due to the decrease in the production of consumer goods and the
invariable consumption expenditure, the prices of consumer goods will rise. At
this point, Hayek argues, the consumers would be inclined to restore their real
consumption to the former level, if possible, by spending more money. The money
income of laborers working in the producer goods sector will increase, because
more money will go to the entrepreneurs in this sector. The laborers can spend
their extra money income on consumption. The volume of consumer goods, however,
will increase more slowly. As a result, the prices of consumer goods will rise even
higher.
The
lengthening of the roundabout production structure must eventually increase the
output of consumer goods. In the case of forced saving, however, no increase is
assumed to occur. The output of consumer goods will temporarily decrease due to
the lengthening of the roundabout production structure, while expenditure on
consumption will continue to increase. Thus the prices of consumer goods go on
rising. Such is the cumulative process as argued by Hayek.
As
a result of the public’s increasing their expenditure on consumption with the
hope of bringing back real consumption to the former level, there will eventually
occur a reversal of the ratio of consumer goods demand over producer goods
demand, and the prices of consumer goods will rise relatively to those of
producer goods.29
At this
stage we come to case (ii), for the reversal of the ratio is analogous to case
(ii ). The economy will move in the opposite direction from that described above
in case (i ).
We have now examined two representatives of Wicksell’s Influences; we
have seen how critical they were of the quantity theory of money and the
classical dichotomy, and how seriously they endeavored to construct their own
brand of monetary economics.
IV. Keynes
from the Treatise to the General Theory
What about Keynes, then? This is the point
we come to in this section. We will clarify the stance and theory of the Treatise which can be counted among
Wicksell’s Influences, examine his developmental process thereafter, and explain
the features of the General Theory.
1. The Treatise30
A. His View of the State of Economics
On bank rate theories, investment and saving
and the quantity theory of money, the following views are expressed.
Bank Rate Theories – Keynes identifies four bank rate theories so far developed,
regarding the bank rate as:
(i) the means of regulating
the quantity of bank money;
(ii) the means of protecting a country’s gold
reserves (Keynes evaluates and uses it in his open system);
(iii) having a psychological
influence on price levels;
(iv) influencing investment and savings (Keynes
regards this as the essence of the bank rate. He sees Wicksell (1898) as representing
this idea and coming close to his ‘fundamental equations’31:
Although
the bank rate plays a pivotal role in Keynes’s theory, money supply has a part
to play as well. This may have something to do with Wicksell’s construction of
his theory in an organized credit economy, and Keynes’s criticism that Wicksell
does not succeed in ‘linking up his theory of bank rate to the quantity
equation’ (TM.1, p. 167).
Keynes explains his ‘general theory of bank rate’ as an extension of
(iv) as follows.
(a) Suppose that the market rate, say, rises above
the natural rate of interest; this will cause the demand price of investment
goods to fall, resulting in a decrease in investment. A rise in the market rate
of interest will, at the same time, cause savings to increase, though not by an
equal amount. Thus investment will decrease more than savings increase.
(b) A fall in the price level of investment goods
will cause production to decrease (which means a decrease in the value of
investment). In addition, since an increase in savings means a decrease in
consumption, the price level of consumption goods will decrease. Thus the price
level as a whole will fall.
(c) When producers incur losses, they will cut the
level of employment at the existing rate of earnings. If this situation continues,
unemployment will increase until the rate of earnings is reduced.32
Keynes argues (a) with ‘the second fundamental equation’ in mind. The
first point in (b) is based on the TM supply function (to be explained later)
in the investment goods sector, the second on ‘the first fundamental equation’.
Investment and Saving – Keynes stresses that investment is not usually equal to savings,
offering two reasons.
(i) Those who determine the division of the
total output are not the same as those who determine that of the total income.
(ii) Earnings
and savings do not include entrepreneurs’ profits (or losses), while the value
of investment does.
The Quantity Theory – Keynes’s criticism
of it runs as follows.
(i) It deals with various
kinds of ambiguous price levels.
(ii) It fails to distinguish
between income, business, and savings deposits.
(iii) It cannot analyze a
dynamic process in which changes occur in the price level due to a divergence
between investment and saving.
Underlying his criticism is
an important conviction to the effect that unless the influence of the bank
rate upon investment and saving and the distinction between earnings and
profits are introduced into analysis , the dynamic process of price formation
cannot be captured. He asserts the advantage of the ‘fundamental equations’ and
gives priority to the bank rate over the quantity of money.33
B. The Theory
The most significant feature of the Treatise theory may well be seen in the
coexistence of a Wicksellian theory and ‘Keynes’s own theory’ (to be explained
below).
(1) Explanation of the fluctuations of the
price level in terms of the relation between the money rate and the natural
rate of interest, and explanation of the working of the economy based on it.
(2) Stress on a bank rate policy as
stabilizing the price level.
(3) Acceptance of an equivalence between
Wicksell’s three conditions for monetary equilibrium.
It should be noted, however, that the main reason
why Keynes himself regards his theory as belonging to Wicksell’s Influences is his
adoption of the idea that the bank rate influences investment and saving. In
the Treatise this is used to provide
a mechanism in which economic stability (stability of the price level and the
volume of output) can be attained by means of a bank rate policy.
Keynes’s Own Theory – At the same time, Keynes develops his own theory. This consists of
two parts, one of which addresses the determination of variables relating to
consumption goods and investment goods in ‘each period’.
(Mechanism 1)
The cost of production and the volume of output are determined at the beginning
of the current period. Once the expenditure for consumption goods is determined
on the basis of earnings, it is automatically realized as the sale proceeds of
consumption goods, and the price level and the profit are simultaneously
determined.
(Mechanism 2)
The cost of production and the volume of output are determined at the beginning
of the current period. The price level of investment goods is determined either
in the stock market or as the demand price of capital goods. The profit is
determined as a result.
The
other part deals with the determination of variables between one period and the
next.
(Mechanism 3) The behavior of entrepreneurs is
such that, if they make a profit (loss) in the current period, they will expand
(contract) output in the next.
We
will refer to this behavioral function as the ‘TM supply function’.
Now,
‘Keynes’s own theory’ can be expressed as the dynamic process consisting of
Mechanisms 1 and 2 working through Mechanism 3.
2. After the Treatise
We regard the Treatise as
propounding a monetary economics critical of neoclassical orthodoxy. How did he
develop his theory after the Treatise
and come to arrive at the General Theory?34
After the Treatise
Keynes went on applying Keynes’s own theory, disregarding Wicksellian theory. It is crucially important to address the question of how Keynes
dealt with the relation between profits and the volume of output. In the Treatise,
the importance of this relation (the ‘TM supply function’) is stressed as
expressing the dynamic mechanism. Keynes adhered to this function after the Treatise,
in spite of much criticism. ‘The
Monetary Theory of Production’ manuscript, written in mid-193235, epitomizes
this stance.
Toward the end
of 1932, however, he eventually abandoned the TM supply function, albeit hesitatingly,
and put forward a new formula of a system of commodity markets in ‘The Parameters of a Monetary Economy’
manuscript, written at the end of 1932.36 This was a turning point
toward the General Theory. 37
It was not until 1933 that Keynes came to put forward a model of how
the volume of employment is determined. 38
Thereafter he took pains to elaborate his model,
continuing to revise the concept of effective demand, the concept of marginal
efficiency of capital, the theory of liquidity preference and various other points.
Here, given the constraint of
space, we must omit Keynes’s process of development thereafter which led up to
the General Theory. 39
3. The General Theory40
Through a
zig-zag process Keynes published the General
Theory in February 1936.
We
can identify two central themes running
through the General Theory: Contrasting
Potentialities and Monetary Economics.
A. Contrasting
Potentialities
Keynes
sees the market economy as possessing two contrasting potentialities.
Stability, certainty and
simplicity – Keynes
argues that the market economy is equipped with several built-in stabilizers,
so that it has an inherent tendency to converge to equilibrium. Based on this
optimistic vision, he constructs a theoretical model in which the level of
employment is determined where the aggregate demand function intersects the
aggregate supply function.
Instability, uncertainty and
complexity – At
the same time Keynes repeats that the stability tendency inherent in the market
economy cannot work unless some conditions are met. Failing them, it is doomed
to fall into instability. Thus we are faced with a structure built on fragile
foundations.
Keynes seems confident, all in
all, that an economy stuck in underemployment equilibrium could be cured with a
public works program and a low interest rate policy.
B. Monetary
Economics
Keynes
puts forward his theory of underemployment equilibrium as monetary economics, as distinct from real economics. He argues
that the monetary economy in which we live can be analyzed only within a
framework of monetary economics. Keynes’s fundamental idea is expounded in Ch.21,
I, where he presents two ways of dividing up economics
One is a division ‘between the
theory of the individual industry or firm and of the rewards and the
distribution between different uses of a given quantity of resources on the one
hand, and the theory of output and employment as a whole on the other hand’ (GT,
p. 293). The other is a division ‘between the theory of stationary equilibrium
and the theory of shifting equilibrium’ (GT, p. 293).
In both cases, the criterion of division
hinges on money. When dealing with the determination of the level of output and
employment as a whole in the real world, we must consider the role played by
money. This is what Keynes means by monetary economics. No wonder Keynes
allocates so much space to the rate of interest (Chs. 13, 14, 15, 17, 23 and
24).
Arguably the General theory rejects
Wicksell’s theory of cumulative process. Keynes also criticizes the notion that
credit creation by the banking system makes investment possible without any
corresponding saving, and the theory of forced saving (both were taken by
Myrdal and Hayek), stressing the need to allow for interaction in the working
of the economy, and equality of investment and saving.
V.
Keynesian Revolution and the Neoclassical Synthesis
The General
Theory exerted a profound influence on economic theory and policy (the
Keynesian Revolution) in the post-war world. The ensuing revolution embodied
four elements.
Firstly, in the controversy over employment
policy in the 1940s Keynes and the Economic Section used a simplified Keynesian
theory of a 45-degree type, and worked out various policy tools such as
built-in-stabilizers.41 Secondly, Keynes’s theory developed in
tandem with elaboration of the national income accounting to which he contributed
with Stone and Meade.
Thirdly, Keynes’s theory developed
in the form of the IS-LM model. This was formulated, immediately after the publication
of the GT, by Hicks, Harrod, Meade
and others, and acquired the status of orthodoxy. Fourthly, Keynes’s theory developed
hand in hand with econometrics (though Keynes was very critical of it).
Under the impact of these elements,
the age came in which almost all the economists were Keynesians ‘after a
fashion’, and so opened the period when Keynesian economics
swept the world in terms of economic theory and policy. The IS-LM model in
tandem with econometric modeling has come to occupy a central position in
macroeconomics and economic policy as well as in pedagogy, Klein and Goldberger
(1955) being an emblematic work.
Another important economic theory – Walrasian GET – which had
captivated mathematical economists in inter-war Europe and Japan, was further
elaborated in terms of mathematics in the USA. Arrow and Debreu (1954) is the
exemplary work in this field.42
Thus the paradigm, ‘Neoclassical
Synthesis’, which was coined by Paul Samuelson, emerged in which
Keynesian economics as macroeconomics and the GET as microeconomics ruled the
roost. This suggests that the IS-LM
model applies in the underemployment situation, but once full employment is
attained (through implementing Keynesian monetary and fiscal policies) the
economy could behave in accordance with Walrasian GTE. Thus almost all the economists
were Walrasians as well.
It should be noted that the Neoclassical Synthesis showed a tendency
to be ‘eclectic’, for Keynesian economics tended increasingly to be conceived
and formulated in terms of Walrasian GET. This shows some contrast not only
with Keynes himself but also with the Wicksell’s Influences, all of whom were
critical of the neoclassical orthodoxy, and aimed at their own monetary
economics, as we saw in Sections III and IV.
No wonder, then, if even the following questions arise at this point:
is this what Keynes aimed at in the General
Theory? Could such eclecticism prove viable? Could monetary economics
co-habit with real economics?
It was under these problematic circumstances
that Clower (1965) and Leijonhufvud (1968) advanced an alternative
interpretation of the General Theory, criticizing the IS-LM paradigm.
This group of economists (the ‘Disequilibrium Approach’. Hereafter the DA) shares
the view that the General Theory analyses an economy in disequilibrium
while Walrasian GTE takes an economy in equilibrium.43
Clower put forward the ‘dual decision hypothesis’,
reappraising the consumption function from the point of view of the behavior of
a household under excess supply of labor. Patinkin (1964, Ch.13) analyzed the
behavior of a firm whose sale proceeds were restrained by the aggregate demand.
The two were integrated as a general disequilibrium theory by Barro and
Grossman (1971).
Almost all the disequilibrium approaches
presuppose fixed prices and money wages. In this respect Negishi’s theory
occupies a unique position, for he analyzed why they tend to be fixed.
VI. Negishi’s Theory of Microfoundations
This section
runs as follows: (1) Negishi’s grasp of the relation between Marshallian
microeconomics and Keynesian macroeconomics, and his understanding of Keynesian
macroeconomics; (2) Negishi’s theory of microfoundations ; (3) Comparison
between his theory and the DA.
1.
Marshallian Microeconomics and
Keynesian Macroeconomics
A. The Relation
Negishi argues that Wicksell’s system is composed
of the theory of cumulative process and Walrasian GET, endorsing tâtonnement
and the classical dichotomy.45 Negishi’s major concern here is to distinguish
between those who support tâtonnement and the classical dichotomy and those who
aim at non-tâtonnement and monetary economics. He places Wicksell and Walras in
the former camp, assigning Marshall and Keynes in the latter.
Negishi argues that unlike Walras,
Cassel, Wicksell, Pigou and Fisher, Marshall analyzes the real world, introducing
money from the start and refusing the classical dichotomy. Because, he
continues, the Principles (Marshall, 1890) presents a theory based on non-tâtonnement
and includes, in substance, a kinked demand curve of a ‘representative’ firm,
it could provide the microfoundations for Keynesian macroeconomics, the essence
of which lies in quantity adjustment under the fixed-pricing system.46
He sees the relation between the
two in terms, as it were, of division of labor. The level of employment and
output is determined through effective demand by Keynesian macroeconomics,
while, given the macroeconomic situation, the behavior of a ‘representative firm’ or a ‘representative household’ is explained
in terms of Marshallian microeconomics.
B. Keynesian
Macroeconomics
Negishi
stresses three points as characterizing Keynesian macroeconomics: (a) monetary
economy; (b) stability of the real wage; (c) asymmetrical change in prices and
wages with respect to excess demand.47
Points (b) and (c), he argues, come
from empirical studies (point (b) is derived from the studies of Dunlop and
Tarshis; point (c) from the Phillips curve), and are connected with Negishi’s
rejection of ‘the first postulate of classical economics’. Whatever Keynesian
macroeconomics might be, Negishi maintains, it should satisfy these points.
Negishi argues that Keynesian
economics – both at the macro and micro level – should be a theory which
explains the possibility of ‘Keynesian equilibrium’ accompanying involuntary
unemployment.
He considers that Keynesian
macroeconomics should be a theory which determines the total quantity of output
in a state of disequilibrium, and uniquely determines the output of an
individual industry, which means assuming a unique correspondence between a set
of the volumes of output of individual industries and the aggregate volume of
output. In addition, he deems, there exists a discrepancy between the volume of
output of an individual industry and the volume of output of the individual
firms within this industry.48
He further argues that because of
a great discrepancy between Keynesian macroeconomics and Keynesian
microeconomics , the former cannot be derived through an aggregation procedure from
the latter.
Negishi might be seen, although he
does not explicitly say so, to accept the IS-LM approach as determining the
total level of employment and output in a state of disequilibrium under the
fixed-pricing system.
2. The Theory of Microfoundations
A. The Theory
In the case of the goods market, according to
Negishi, a representative firm has its inverse perceived demand function which
has a kinked point (the fixed price, the output realized). Applying this
concept, he explains why prices tend to be fixed in a perfectly competitive
market with imperfect information in a state of
disequilibrium. He maintains that the
Keynesian microfoundations should be constructed on this basis. Although he
extends this idea to the labor market, the problem of marketing costs, and so
on, we will take here the case of the goods market.49
Suppose that an inverse perceived demand function of a
representative firm is expressed as p = f (y, p*, y*), and the total cost
function as g( y, w). The profit function is expressed as π= py – g (y,
w).
Then the equilibrium condition is obtained, given the wage rate w,
by maximizing the profit with regard to y , subject to y = y* (the realized
condition of output). The inverse perceived demand function is assumed to pass
the point (p*, y*).
(y is the volume of output, p the price, y* the volume of output at
an initial point, and p* the price at an initial point.)
The solution at the point
(p*, y*) is
p* (1 −e+) – ∂g/∂y ≦ 0 … (1)
p*( 1 −e -) – ∂g/∂y ≧ 0 … (2)
Equation (1) is
the right-hand side condition at the point (p*, y*), showing that the marginal
revenue should be less than or equal to the marginal cost, while equation (2)
is the left-hand side condition at the point (p*, y*), showing that the
marginal revenue should be more than or equal to the marginal cost.
If the two equations are in a
state of inequality, p* (= p) remains independent of y* (=y), which means that
even if the activity level of a representative firm changes, the price would
remain unchanged.
B. Two Features
(i) The
rigidity of prices at the micro level explained in Negishi’s theory has the
effect of reinforcing the rigidity of prices at the macro level. That is, if
transactions in the economic system are made in a state of disequilibrium under
the fixed-pricing system, the microeconomic behavior of a representative firm or
household contributes to strengthening the rigidity of prices.
(ii) Negishi’s
theory supposes a unique relation between macroeconomics and microeconomics.
According to this theory, the volume of output of an individual industry (or a
representative firm) is to be determined by means of Keynesian macroeconomics.
However, the demand and the supply there should be naturally derived from some
microeconomic situation. Otherwise the demand and the supply would not
correctly reflect the behavior of individual decision-makers, with the result
that any decision-maker would not be able to judge, on the basis of the
quantity demanded and the quantity supplied, whether the market concerned was
or was not in excess demand. It would be difficult, then, for a firm to
perceive an inverse demand function.
3. Comparison
with the DA
Negishi rates
the DA highly. Whenever he refers to it, no critical comment seems to be
forthcoming, in contrast with his comments, for example, on real economics.
We might compare Negishi’s theory
with the DA on three points.
(i) The
DA insists that the revolutionary nature of Keynes’s economics lies in having demonstrated the ‘partiality’ of
Walrasian GTE, which is characterized by the absence of money, and the
assumption of tâtonnement, and in having established a general disequilibrium
theory, which includes Walrasian GTE as a special case.
(i ') Negishi does not argue the relation
between Keynesian economics and Walrasian GTE in terms of generality or
partiality. Although he uses the absence of money and the assumption of
tâtonnement as a criterion of judgment, what he earnestly maintains is a
complete difference between the two in their approach towards economic analysis.
(ii) The DA argues that Keynes’s theory aims
at analyzing the market economy in which quantity (or income) adjustment works
under the fixed-pricing system.
(ii ') Negishi shares this view.
(iii) The DA distinguishes Keynes’s economics
from Keynesian economics (or the IS-LM model).
(iii ') Negishi makes no distinction between
Keynes’s economics and Keynesian economics. It may in fact be that he sees the IS-LM
model as effective in analyzing the macroeconomic situation.
VII. Conclusion
In the course of this paper we have identified
some representative monetary economics.
We started our investigation with the extent to which Wicksell’s
theory of cumulative process influenced monetary economics of Myrdal, Hayek and
Keynes (of the Treatise). We then
went into Keynes’s theoretical process from the Treatise to the General
Theory.50 Keynes put forward the monetary economics of underemployment
equilibrium in the General Theory,
departing from Wicksell’s influences, and succeeded in bringing about the
Keynesian Revolution in post-world economics, although the essence of the
revolution continues to be interpreted in divergent ways. Finally we examined
how Negishi constructed a theory of microfoundations for Keynesian Economics. This
was developed in the 1970s when the Neoclassical Synthesis was coming to end.
Negishi maintained that Keynesian macroeconomics characterized as monetary
economics, which is in sharp contrast with real economics as endorsing the classical
dichotomy and Say’s Law, should be based on Marshallian microeconomics.
All of them strove to construct their own version of monetary
economics, criticizing the neoclassical orthodoxy which endorses the quantity
theory of money, Walrasian GET, the classical dichotomy, and Say’s Law. The
theories they came up with show , of course, appreciable differences. We might
say that it is precisely these differences that reveal the originality of each,
reflecting the respective academic backgrounds and/or circumstances.
1) Wicksell’s economics should not beseen as monetary economics as
defined below. However, he made a great contribution to its development.
2) See
Chiodi (1991, p. 48-50). The difference between Wicksell and Mises is examined
in Bellofiore (2000, p. 549-54).
3)
For the difference between Wicksellian and Walrasian GET, see Rogers (1989, Ch.
2).
4)
See VCR, p. 82-92.
5) See VCR, p. 95.
6) See VCR, p. 153-61.
7) See IP, p. 165-7.
8) See IP, p. 135.
For the debates between Wicksell, Davidson and Åkerman on Wicksell’s theory of cumulative
process, see Siven (1998). Wicksell (1913) is a rejoinder to Davidson.
9) Wicksell
(1889, p. 514 in Boianovsky and Trautwein, 2001) ascribes his theory of cumulative process to Ricardo (1810).
10)
Stressing the ‘supply of deposits’ rather than ‘real shocks and rate
differentials’, Humphrey (1997) regards Wicksell as ‘a bona fide quantity
theorist’. The reverse might be true, for the ‘supply of deposits’ is passively
determined in Wicksell’s theory.
11) Myrdal, Lindahl and Mises
follow this.
12)
See IP, p. 125-7.
13) We follow Wicksell’s
class division of society.
14) ‘The Great Depression’ in the fourth quarter of the 19th century
saw a gradual fall in prices together with full employment. Wickesell’s theory
reflects this. It was not until the early 1920s that he became concerned with
change in output and employment. See Boianovsky (1998).
15)
With regard to the argument that incomes determine the price level of
consumption goods, Wicksell refers to the first half of Tooke’s thirteenth
proposition. See Wicksell (1898, p. 44). This is accepted by Lindahl (1939, p. 142),
Myrdal (1939, p. 22), and TM.1, p. 122.
16) They cover the same area as Leijoinhufvud’s ‘Wickesell
Connection’ (1981) with different implications.
17) Aoyama’s contemporaneous studies are worthy of notice. He
maintains that a theory of dynamic general equilibrium can effectively represent
a criticism of Say’s law, as can be seen in Robertson (1926). See Aoyama (1953)
and Negishi and Ikeo (1999).
18) Myrdaul indicates Walras, Cassel, Pareto and Fisher. See ME,
p.11.
19) See ME, p. 11-2.
20) See ME, p. 14-5.
21) See ME,
p. 16-7.
22) See ME, p.90. Y is not
used in the original.
23)
See ME, p.79. In the original, c１′ and r １′ are written as c１ and r１ respectively .
24) Endogenous variables are Y, Q, R2, C and P1.
25) See Hayek (1931, p. 3-4). Mises (1912, p. 91-92) argues that the quantity
theory fails to explain variations in the value of money in terms of subjective
valuation.
26) See Hayek (1931, p. 25-26). For relations between Wicksell, Hayek
and Mises, see Bellofiore (1998).
27)
The volume of consumer goods is assumed to increase more slowly than consumption.
See Hayek (1931, p. 88).
29)
In Mises and Hayek the money rate of interest is defined as the prices of
consumer goods over those of producer goods.
30) See Hirai (2008, Ch.5, ‘The Treatise’).
31) See TM.1, p. 198-9.
32) See
TM.1, p. 171.
33) See TM.1, p. 196-7.
34) This is the main theme in Hirai (2008, Chs. 6-12).
35) JMK.13,
p. 381-96. See Hirai (2008, Ch.6, ‘After the Treatise’).
36) JMK.13,
p. 397-405.
37) See Hirai (2008, Ch.7, ‘The Turning
Point’).
38) See Hirai (2008, Ch.8, ‘Searching for a
New Theory of Employment’).
39) See Hirai (2008, Chs.9, ‘Establishment
of the Investment and Consumption Theories’, 10, ‘The Eve of the General Theory’, 11, ‘The Proofing
Process (I)’, and 12, ‘The Proofing Process (II)’).
40) See Hirai (2008, Ch.13, ‘The General Theory’).
41) See Hirai (2008, p. 39).
42) There occurred a serious problem with the GET thereafter. For
this, see Kirman (1989).
43) For a recent evaluation for DA, see, for example, Backhouse and
Boianovsky (2005).
44) Ironically New Classical theories of business cycle represented
by Lucas (1975), Kidland and Prescot (1982) are macroeconomics, although they
stress their rigorous microfoundations .
45) See Negishi (1981, Chs. 10-12).
46) See Negishi (1989, Ch. 10).
47) See Negishi (1979, p. 31-3).
48) See Negishi (1974b, p. 11).
49) The following model comes from Negishi (1974a).
50) On the process from A
Tract on Monetary Reform (Keynes, 1923) to the Treatise, see Hirai (2008, Ch.4, ‘From the Tract to the Treatise’).
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* I appreciates valuable comments by Profs. M. Bianovsky (Univ. of
Brasilia) and Hans-Michael Trautwein (Univ. of Oldenburg) as well as A. Ikeo
(Waseda Univ.), who greatly contributed to improvement . The remaining errors
are mine.
