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The Keynesian Gospel According to Modigliani 331
kPX
= M s
(15.2)
In what follows, we will refer to the “monetary mechanism” as the mechanism
that insures the clearing of the money market, i.e. that equation (15.2) is
satisfied.
We will show that the mechanism proposed by the classics is unacceptable for
it relies on the counterfactual assumption that wages are highly flexible downward,
i.e. that they decline promptly in the presence of excess supply of labor or
(non-frictional) unemployment. Keynes instead elaborates a mechanism that is
valid regardless of the degree of rigidity of wages. It is the formulation of this
mechanism that constitutes his crowning achievement.
II The Classical Monetary Theory
II.1 The Determinants of the Price Level and the Quantity Theory of
Money
The essence of the classical monetary theory is very simple: money and the
money market has one single role to play: to determine the price level, while
having no effect on any other real variable. It rests entirely on the (counterfactual)
Postulate of wage-price flexibility: in the presence of excess supply,
wages-prices decline promptly toward the equilibrium level reducing the excess
supply until it has disappeared. Since this assumption insures that every market
(including the labor market) always clears, aggregate output X, must be fixed,
pegged at the “full employment output,” say X¯ , which at any time can be taken
as a given. If one substitutes X¯ for X in (15.2), one obtains the classical demand
equation
M d = kX
P
Since at any point of time, X¯ and k are given “real” variables, independent of
M, reflecting the size of population, the state of the arts (productivity), payment
habits of M, they can be taken as constant, so that the demand for money turns
out to depend on a single variable P, and to be proportional to it. This demand
equation is shown in figure 15.2, as MM. It is a straight line through the origin
of slope kX¯ . The supply can again be taken as exogenous, M s , and represented
by the horizontal line at that height. Equilibrium P, P¯ is found at the intersection
of demand and supply. Its value is given by the solution for P of the equilibrium
condition M d = kX¯ P = M s or
s
s
P = M kX = M V X
(15.3)