Rabin A Monetary Theory - 196 200

Disequilibrium economics (1)
185
much labor would households supply if they could obtain indicated amounts
of commodities?
In Figure 6.2, the curves for firms and households intersect at point E. In the
region between the curves inward from this point, at a given volume of output,
labor offered by households exceeds the labor necessary to produce that output.
At a given level of employment, conversely, the output producible with that
much labor exceeds the output whose availability is necessary to motivate the
supply of that much labor. On either view of the situation, interacting pressures
operate to increase output and employment.
In the region outward from point E, at a given level of output, the labor
supplied by households falls short of the amount necessary to produce that
output. At a given level of employment, conversely, the output producible falls
short of the amount necessary to motivate the supply of that much labor. From
either point of view, interacting pressures are at work to shrink output and
employment. Shrinkage of the amount of commodities available leads
households to withhold their labor all the more, while reduced labor input entails
further shrinkage of commodity output.
Point E represents the quasi-equilibrium of Chapter 3. Excessive real cash
balances have reduced output and employment from their full-employment
equilibrium levels at point A. Yet output and employment do not fall all the
way to zero. Furthermore, point E is a disequilibrium, since people and firms
are frustrated. The transactions-flow excess demands for commodities and labor
are matched by an effective transactions-flow excess supply of money. Upward
pressure on wages and prices still exists.
A certain symmetry holds between the cases of generally deficient and
generally excessive aggregate demand. Both cases illustrate how monetary
disorder can obstruct the process of exchange. The disorder is not, of course,
purely monetary. Rigidity or stickiness of wages and prices is also involved. For
if they always moved swiftly to their market-clearing levels, any nominal
quantity of money would be an equilibrium real quantity. Still, any impairment
of exchange by that very token impairs production of goods destined to be
exchanged. Again the simple point stands out that goods exchange for goods
but through the intermediary of money.
Impairment of activity by overall excess demand is presumably of slight
practical importance. First, if workers ever do experience frustration in spending
their money, they may well expect the situation to be temporary only. Instead
of responding entirely by withholding their labor, they may go on working and
accumulate savings to spend when commodities become available again. Such
behavior was evident during World War II. Second, sales from inventory by
real-world firms lessen the frustration of worker-consumers and limit the
perverse interaction described above. Third, wages and prices are not rigid.
186
Monetary theory
Some commodities may be in short supply, but realistically, workers will still
find some things to spend their earnings on.
Nevertheless, the excess demand case has more than theoretical interest.
Historical examples can be found, as in Germany before the monetary reform
of June 1948. Despite an inflated money supply, the price and wage controls
of the Hitler era remained in force under the Allied occupation, entailing
excessive cash balances, consumer frustration, and worker absenteeism. Instead
of remaining at work earning more of the money that was so hard to spend
anyway, workers found it sensible to take time off for expeditions to the countryside to engage in barter with the farmers. This was especially true because
trips on the government railroads were among the few things that people could
successfully spend money on and were bargains at the fares charged. Contemporary accounts describe jam-packed trains, with passengers sitting on the roofs
and clinging to the sides.
Then the reform lifted price controls and drastically shrank the quantity of
money. Again it was sensible to stay at work producing things, for money
earned became the key to obtaining commodities, now available. Economic
activity zoomed almost overnight. The great contrast provided further insight
into the earlier disequilibrium.
MONETARY EXPANSION AND A RISE IN OUTPUT

In the more intuitively plausible second case of an increase in the money supply
at full-employment equilibrium, this increase can temporarily raise output and
employment beyond their initial levels, and without necessarily reducing the real
wage rate. Here a stimulus comes from monetary expansion not fully absorbed
by price increases.
When the money supply and spending increase, business firms encounter
strengthened demands for their products. Quite generally, each firm or the
average one is willing to meet increased demand with increased sales, and at a
substantially unchanged price, as long as it can get the necessary capital goods,
materials, labor and other inputs at unchanged cost. Whether it can get them
depends largely on other peoples willingness to run down their inventories,
work their factories more nearly at maximum capacity, work overtime, take
less leisure between jobs, enter the labor force, postpone retirement and so forth.
To some extent, other people are willing to do so. A chief reason for holding
inventories in the first place is to be able to accommodate possibly temporary
spurts of demand over output. Moreover, sellers of finished goods, goods in
process and materials are willing to draw down inventories without price
increases if they think they can readily replenish them. So now the average firm
is willing to order more inputs and offer more jobs. Even though wages may
187
not have risen, workers more easily find jobs as good as they already considered
satisfactory; less job search is necessary. Workers are willing to put in more
overtime or to postpone taking time off between jobs because they think they
might as well seize overtime or job opportunities while available. Their response
is, in a sense, an increase in the current supply of labor. Consequently, sales
and output expand.
In this story, nothing on the wage side has changed to make expansion more
attractive to firms. Rather, the individual firm sees a chance to do more business.
In effect, its curve of marginal physical product of labor has shifted to the right.
This curve for any factor is conventionally drawn against the background of
supposedly fixed amounts of other factors. But here the firm is not thinking of
a worsened mix of labor in relation to other factors. Rather, it expects to be
able to put increased quantities of other factors into use along with labor. (And
capital equipment is not always fully employed. Some flexibility exists in the
system.) Furthermore, the easier sale of output means that the curves of
marginal revenue product and of marginal revenue product deflated by price
have shifted to the right. The concept of marginal revenue product recognizes
that a firms demand for labor depends not merely on how much the labor can
physically contribute to production but also on what this additional physical
output can add to the revenue of the firm. Extra physical output that cannot be
sold adds nothing to the firms revenue.
Since it takes time for prices to rise as explained in Chapter 7, output may
expand in the meantime, and activity may temporarily exceed its fullemployment level. Perceptions have been at work that eventually result in what
superficially looks like a fallacy of composition.
Actually, there is none. There would be one if business firms and workers
were making the above-mentioned decisions as a single aggregate entity. But
they are deciding individually. And each one, from his own point of view, is not
committing a fallacy or being fooled. (Fooling is essential in the branch of new
classical macroeconomics that relies on misperceptions, as explained in
Chapter 7.) The individual firms opportunity to do a bigger volume of business
at substantially unchanged costs and prices is a genuine one, even though it
will prove temporary. Why not seize it while it lasts? As for the worker, why
should he pass up the opportunity for overtime work that he would be glad to
do some time or other or pass up the opportunity to find a job easily, even
though (or especially though) the opportunity may prove fleeting? Why not
postpone leisure? Firms and workers rationally respond to increased spending
by producing and working more because they have to make their decisions
individually, even though such behavior would be irrational if decided on collectively. No misperception or irrationality is necessarily involved. The key to
the scenario is that people make the relevant decisions in a decentralized,
188
Monetary theory
piecemeal, nonsynchronous manner. (We examine the important concepts of

individually and collectively rational behaviors on pages 1956.)
How does this scenario ever end? It looks as if everybody has become happier
than before at no cost. By its very nature, however, the situation can last only
a while. Inventories available to be run down are not unlimited in size, nor are
workers willing without limit to postpone leisure. Inflated demands get transmitted back to primary materials and factors of production, bidding up their
prices and creating what superficially looks like a cost-push process (see pages
below). The inflated flow of spending impinges on limited real supplies (and
supply schedules), and the economy turns out only temporarily escaping the
impact on prices that standard theory describes. As resource and inventory limitations manifest themselves, as costs and prices and living expenses rise, and
as the initially attractive sales and job opportunities accordingly come to look
less attractive after all, the initial quantity impact of the inflated aggregate
spending gives way to a price impact. P rises and Q drops back, even if MV
remains at its new inflated level. Output and employment drop back again after
temporarily rising beyond their sustainable rates.
Three points deserve emphasis. First, although price increases may
accompany the monetary stimulus to output and employment, they are far from
being an essential part of the process and are actually in rivalry with the
stimulus. Second, although a cut in the real wage rate might indeed have an
expansionary effect on output, it is not necessary for that effect (see the next
section). Third, it is unnecessary to decide here whether the gain in output and
employment should ultimately prove to have been only a borrowing against
the future as, later, workers recoup postponed leisure and suppliers rebuild
rundown inventories. Even if monetary factors should prove to have affected
real output only by shifting it in time, and if this could happen only in a special
case, the point would remain that monetary factors could indeed have a real
bite even on an initial situation of full employment.
Let us examine the nature of the disequilibrium process in this case. The
initial increase in the money stock raises the demand for commodities. Transactions, production and employment respond. These real accommodations to
increased spending are unsustainable, however. Output eventually falls back
for the supply-side reasons given above. This relapse manifests itself in an
excess demand for commodities and productive factors, matched by an excess
supply of money. The bidding up of costs and prices helps to clear the relevant
markets. On the demand side, the increased prices mean decreased real balances
and real expenditure. Both demand and supply factors, then, reverse the initial
temporary stimulus to output and employment.
The analysis of this section might seem to contradict that of the previous
section, which explains how general excess demand could shrink real activity.
Actually, no contradiction exists. The rise in output in the second case is
189
avowedly temporary. It hinges on rational decentralized decisionmaking, on

workers postponements of leisure, and on suppliers rundowns of inventories,
which serve the buffer purpose for which they were held in the first place. In
the counterintuitive case of Barro and Grossman, workers not only do not
postpone leisure but withdraw some of their labor because they cannot succeed
in spending all of their earnings. Those authors assume, in their book, that firms
hold no inventories (and their article of 1971, p. 85, abstracts from inventory
accumulation or decumulation). While the second case seems more plausible,
the excess demand case of Barro and Grossman could develop, with no significant (further) leisure postponements and inventory rundowns taking place
and with employment and production reduced below their full-employment
equilibrium levels.
REAL WAGES AND THE BUSINESS CYCLE

Keynes (1936, p. 17) attributed to classical economists the belief that real wages
are countercyclical: In general, an increase in employment can only occur to
the accompaniment of a decline in the rate of real wages. Thus I am not
disputing this vital fact which the classical economists have (rightly) asserted
as indefeasible. We question though whether most classical economists ever
squarely faced this issue of the real wage.4 Nevertheless, the belief that real
wages are countercyclical was adopted by Keynesians and later became an
important feature of Milton Friedmans 1967 AEA address. Yet according to
monetary-disequilibrium theory, in the second case of monetary expansion, we
cannot predict whether the real wage will increase, decrease, or remain the
same. If the demand for labor increases more than the supply, then the theory
is consistent with a rise in the real wage. This may be more in accord with
Phillipss (1958) original formulation of the Phillips curve (discussed on pages
20912 below), since a higher nominal and real wage may now accompany
tightness in the labor market. A rise in the real wage would be consistent with
the rise in the marginal productivity of labor.
Numerous empirical studies of the movement of real wages over the business
cycle have provided no firm conclusions (a fact itself suggesting that the association, whether procyclical or countercyclical, is not strong and dependable).
For example, Basu and Taylor (1999) study business cycles from 1870 to 1999
for 15 countries in what they call the largest such panel of data ever studied
over this time frame in terms of country coverage (p. 46). They divide the 130
years covered into four periods according to the distinct international monetary
regime that prevailed at the time. They find that real wages have been more
procyclical recently, which they conjecture may account for the popularity in

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Disequilibrium economics (1)

MONETARY EXPANSION AND A RISE IN OUTPUT

Disequilibrium economics (1)

piecemeal, nonsynchronous manner. (We examine the important concepts of

Disequilibrium economics (1)

avowedly temporary. It hinges on rational decentralized decisionmaking, on

REAL WAGES AND THE BUSINESS CYCLE

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