Modern Macroeconomics.pdf

70 Modern macroeconomicsboth Say’s Law and the classical model of the labour market, Keynes’s theoryno longer assumes that real output is predetermined at its full employmentlevel. In Chapter 21 of the General Theory, Keynes discusses the variouspossibilities. If the aggregate supply curve is perfectly elastic, then a changein effective demand brought about by an increase in the quantity of moneywill cause output and employment to increase with no effect on the pricelevel until full employment is reached. However, in the normal course ofevents, an increase in effective demand will ‘spend itself partly in increasingthe quantity of employment and partly in raising the level of prices’ (Keynes,1936, p. 296). In other words, the supply response of the economy in Keynes’smodel can be represented by an aggregate supply function such as W 0 AS inFigure 2.6, panel (b). Therefore for monetary expansions carried out when Y< Y F, both output and the price level will rise. Once the aggregate volume ofoutput corresponding to full employment is established, Keynes accepted that‘the classical theory comes into its own again’ and monetary expansions willproduce ‘true inflation’ (Keynes, 1936, pp. 378, 303). A further complicationin Keynes’s model is that the linkage between a change in the quantity ofmoney and a change in effective demand is indirect, coming as it does via itsinfluence on interest rates, investment and the size of the multiplier. Weshould also note that, once Keynes had introduced the theory of liquiditypreference, the possibility that the demand for money function might shiftabout unpredictably, causing velocity to vary, implies that changes in M maybe offset by changes in V in the opposite direction. With Y and V no longerassumed constant in the equation MV = PY, it is clear that changes in thequantity of money may cause V, P or Y to vary. The neutrality of money is nolonger guaranteed.2.12 Three Important Interpretations of KeynesIn the vast literature relating to Keynes’s contribution since 1936 we canidentify three distinct interpretations which command varying degrees ofsupport (see Snowdon and Vane, 1997a). Coddington (1983) identifies threeinterpretations, namely: (i) the ‘hydraulic’ interpretation, (ii) the ‘fundamentalist’interpretation, and (iii) the modified general equilibrium approach.2.12.1 The ‘hydraulic’ interpretationThis is the orthodox interpretation of Keynes initiated and inspired by Hicks(1937), Modigliani (1944), Klein (1947), Samuelson (1948) and Hansen(1953). The IS–LM model formed the backbone of theorizing within thisapproach and it dominated thinking in the emerging neoclassical synthesisduring the 1950s and 1960s. Samuelson’s famous textbook, Economics, firstpublished in 1948, played a very important role here, popularizing Keynes