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354 Miscellanea
short of totalitarian dictatorship), to force wages to behave according to The
Postulate. Finally the experience of the last 50 years, cited earlier, makes it
clear that there is no hope that labor will, on its own, behave according to The
Postulate.
But, fortunately, Keynes has an operational and practical answer to offer: don’t
try to pursue the hopeless path of pushing wages down, try the easy way by
pulling the nominal Money Supply up to the right level. As long as the nominal
wage W is effectively rigid, unemployment is curable by increasing M. Since
money is controlled by the central bank, unemployment is caused by an improper
monetary policy. In my opinion this conclusion, although based on a “bare bones”
model, contains the key explanation for the inexcusably high level of unemployment
that Europe is suffering today.
VI.3 Too Little Money or Too High an Interest Rate?
Up to this point, we have stressed the fact that, with rigid nominal wages, employment
can be controlled by monetary policy. But in reality, the Central Bank has
an alternative tool for exercising its control over economic activity, namely the
interest rate—though on condition of giving up control of the other tool, M. It is
clear from figure 15.5 that if the bank were in a position to enforce a given value
of r, like r* in Quadrant I, this would result in investment I*, hence income Y*,
and point a* on the IS curve of Quadrant I.
But how can the central bank enforce r? Essentially by standing ready to buy
or sell some specified kind of assets (e.g., Treasury Bills or other short-term loans)
at a specified yield r*: that yield than becomes the “market rate.” It can make
that offer operational since it has “money” to buy whatever may be offered by
the public at that rate, in virtue of the fact that it can pay with its IOU, which is
money (or the source of money) for the economy. Similarly, if the public wants
to buy, it will tender the bank’s IOU that will be cancelled, reducing the money
supply. Thus the Bank can make r* the market rate. But it is clear that by paying
or receiving Central Bank cash in exchange for the asset, the public will cause a
change in the nominal money supply. Thus the Bank is handing over to the public
the decision of what quantity of M it wants to hold. That quantity will, of course,
be the money demand corresponding to the point a* generated by the chosen r*.
The money demanded and supplied will be an amount M* such that
M * P X * r * kr *
0 = ( ) ( )
Graphically, it is the money supply corresponding to the point A* on the money
demand curve that results in a LM curve that goes through A* in Quadrant IV.
There is only one interest rate, r¯ consistent with X¯ ; it is the interest rate that
the bank should choose, if it decides to use r as the instrument for policy. There