The Neoclassical-Keynesian
Synthesis
Real Balance Effects and the
Neoclassical Response to Keynes
The Neoclassical Response to the
Keynesian Critique
1. Some neoclassical economists became
Keynesians
2. Some tried to ignore Keynes
3. Some misinterpreted Keynes as arguing that
sticky wages and prices could cause
unemployment in the long run (this result was
already in neoclassical economics—if that is all
that Keynes was arguing, then Keynes was not
making a new contribution).
Neoclassical Response to Keynes
4. This next response was the most
interesting: it said, “Keynes is making
some real contributions and we should
recognize that. His theory of the multiplier,
his argument that we should conduct
aggregate analysis and that money should
play a central, determining role, even his
liquidity preference theory, are all real
contributions and should be incorporated
into the analysis.”
Response to Keynes
• “But,” this response continued, “if Keynes
is saying he is refuting neoclassical theory
he is going too far.” “Because,” they said,
“it can be shown that all of these
contributions can be incorporated into the
broader neoclassical framework and it can
still be demonstrated that the central
proposition of neoclassical macro theory
still holds.”
Central Proposition of Neoclassical
Macro
• They argued: “It can still be shown that if
wages, prices, and interest rates are
perfectly flexible that the economy will
tend to full employment in the long run.”
• The argument will look a little different, it
won’t be simply the old neoclassical labor
and loanable funds markets story.
Grand Neoclassical-Keynesian
Synthesis
• This argument, which came to be known
as the neoclassical synthesis, used the
real balance effects arguments to
demonstrate their proposition.
• The real balance effects has two parts: the
direct real balance effect, or Pigou effect,
and the indirect real balance effect, or
Keynes effect, or interest rate effect.
Real Balance Effects
• The real balance effect argument begins by
noting that in Keynes if there is unemployment,
or aggregate supply is greater than aggregate
demand, firms will cut back production, income
will fall, and employment will fall.
• But, they ask, what if instead of cutting output,
firms cut prices in response to insufficient
demand? And if this occurred throughout the
economy, the price level would fall (there would
be deflation). Deflation means that the real value
of money would rise.
Direct Real Balance
(or Pigou) Effect
AS>AD  P ↓  real value of $ ↑  (C + I)↑  mult
effects  Y↑  Yf
When AS>AD, the price level falls, increasing the real
value of money. Consumers and investors holding
cash would feel richer, and consumption and
investment would rise. This would set off multiplier
effects, increasing output and income. As long as
AS>AD, this would continue, until full employment.
Indirect Real Balance (or Keynes or
Interest Rate) Effect
AS>AD  P ↓  real value of $ ↑  amount of $
necessary to satisfy transactions demand for $↓
 amount of $ available for speculative
demand↑  demand for securities↑  bond
prices↑  interest rates↓  (C + I)↑  mult 
Y↑  Yf
Demand for Money in Keynes
Keynes asked the question: “Why would
anyone hold any of their wealth in the form
of cash rather than in higher interestearning or profit-bearing assets?”
He gave three reasons in The General
Theory: transactions demand for cash,
precautionary demand for cash and the
speculative demand for cash.
Demand for Money
Transactions demand – wealth people keep
in the form of cash to make normal daily,
weekly, and monthly transactions.
Precautionary demand – in case of
emergencies (flat tire, broken arm, etc.)
Speculative demand – in case an
unexpected financial opportunity should
arise, to earn higher than normal profits.
inverse relation between bond
prices and interest rates
Suppose a bond that sells for $1000 earns
$50 per year interest. So the interest rate
is 5%. Then suppose the interest rate
rises to 10%. The bond is locked in to a
return of $50 per year, so the price falls to
$500. (think of the alternative of putting
$1000 in the bank at 10%, it would earn
$100, so no one would buy the bond for
$1000 when the return is $50 if the interest
rate is 10%.).
Real balance effects and
neoclassical synthesis
• Notice that the RBE incorporate aggregate
analysis, money as a central determining
variable, the multiplier, and liquidity
preference theory all from Keynes.
• Yet the central proposition of neoclassical
macro still holds—if wages, prices, and
interest rates are perfectly flexible, the
economy tends to full employment in the
long run, no government intervention.
Keynesian reply to RBE
1. yes, if price level falls, real value of $
rises, but what about the real value of noncash assets? So, whether you feel richer
or poorer when there is deflation depends
on whether households and businesses
keep their wealth in cash or non-cash
assets.
Keynesian reply to RBE
2. yes, if price level falls, real value of $
rises, but what about the real value of
debt? Debt is denominated in cash, so real
value goes up when price level falls.
Whether households and businesses feel
richer or poorer when there is deflation
depends on the importance of debt
(consumer debt, corporate debt, and
government debt as well).
Keynesian reply to RBE
3. Consideration of expectations
complicates the RBE stories. If
consumers and investors do not know if
prices and interest rates will continue to
fall, they may not buy (and borrow to buy),
but wait and see if they fall more. And if
they do not buy (and borrow), then prices
and interest rates continue to fall. How
high will the real value of debt inflate
before they think prices and interest rates
have hit rock bottom?
Keynesian reply to RBE
4. Lower prices may be good for buyers, but
are they good for sellers? It depends. If
you are thinking about investing in
producing widgets because interest rates
are down, and you see the prices of
widgets falling, there is a limit to how low
prices can go before it is a dis-incentive for
you to expand output in that market.
Keynesian reply to RBE
5. Indirect real balance effect reintroduces
the mechanistic inverse relation between
interest rates and investment that Keynes
criticized. (this applies only to the indirect
real balance effect).
Keynesian reply to RBE
6. Historical experience and empirical record
a. Great Depression – deflation, but no
real balance effects. Interest rates zero, no
investment.
b. Post WWII experience of industrialized
nations. Many periods of unemployment,
but virtually no deflation. (slowing of
inflation not the same as deflation)