7. Money in a Keynesian economy It’s not a moving equilibrium. When we have 11 percent unemployment in 1982 or 25 percent in 1932, I don’t regard that as being a labor market equilibrium with supply and demand equal. And I don’t believe that productivity, technology, go up and down in anything like waves which would be consistent with the business cycles we observe. (James Tobin, quoted by Fettig, 1996) INTRODUCTION The classical model oﬀers a ﬁrmly grounded rationalization of important macroeconomic phenomena such as inﬂation (especially hyper-inﬂation), and even ﬂuctuations in real output. Indeed, prominent contributors to the RBC (real business cycles) literature argue that technology shocks explain 70 percent of the post-war (WWII) economy’s ﬂuctuations (see Rolnick, 1996 and Romer, 2001, Table 4.4). But this model encounters diﬃculty when attempting to rationalize phenomena such as involuntary unemployment, and ﬂuctuations therein. In addition, persistent reduced form evidence suggests that, at least in the short run, money is not neutral.1 The Great Depression shed a bright light on these diﬃculties, encouraging that era’s most prominent economist, John Maynard Keynes, to consider how aggregate demand can aﬀect employment and output. A distinguishing feature of these early models is an allowance for nominal rigidities. Recall the classical assumption that constituent prices move together (on average), and its implication that aggregate supply does not vary with the price level but remains ﬁxed at a level consistent with the labor market’s competitive equilibrium. By instead assuming that prices...
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