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Monetary theory
Real
output
A
Households
(dashed)
Households
(solid)
Firms
Full employment
Employment
Figure 6.1
employment. Its positive intercept on the output axis shows that people would
demand some commodities even at zero employment, paying out of savings.
In the region between the two curves nearer the origin from their intersection at point B, the firms curve shows more labor being effectively demanded
at a given level of output than the amount of employment that, according to
the households curve, would generate enough demand to absorb that much
output. At a given level of employment to shift the point of view the output
produced according to the firms curve is less than the output demanded
according to the households curve. Either point of view indicates interacting
upward pressures on employment and output.
In the region outward from point B, at a given output less labor is demanded
according to the firms curve than the volume of employment necessary,
according to the households curve, to sustain a demand for that much output.
At a given level of employment, the output produced according to the firms
curve is greater than the output demanded according to the households curve.
Interacting downward pressures are at work.
Point B corresponds to the quasi-equilibrium. On this interpretation, the
diagram is loosely similar to the standard Keynesian 45-degree-line diagram of
the textbooks. One difference here is that employment rather than income is
measured along the horizontal axis. (Keynes himself, in his General Theory
181
(1936), described but did not actually draw a diagram with employment
measured along the horizontal axis and demand for and supply of output along
the vertical axis.) Barro and Grossmans curve for firms is loosely analogous
to Keyness aggregate supply function, which shows the volume of expected
purchases of output that would just make it worth while for firms to offer the
corresponding volume of employment. The curve for households is loosely
analogous to Keyness aggregate demand function, which shows the volume of
households purchases of output that businesspeople do expect at the corresponding volume of employment. (Barro and Grossman did not point out these
analogies and bear no responsibility for our interpretation.)
Barro and Grossman (1976, p. 62) emphasize that a real wage rate above the
equilibrium level is a sufficient condition, but not a necessary condition, for
underemployment. In the case presented here, underemployment traces to a
deficient demand for commodities. The real wage could be at or even below its
full-employment equilibrium level. Barro and Grossman mention that cuts in
the real wage might superficially seem to be a remedy. Wage cuts might reduce
and eventually eliminate the excess supply of labor by decreasing the amount
of labor effectively supplied. They would not, however, achieve fullemployment equilibrium.
182
Monetary theory
LIMITS TO CONTAGION
Our expository apparatus must not mislead us into supposing that the process
of cumulative disequilibrium and recovery works with precision. In the real
world, the behaviors of inventories and money limit its self-feeding character.
One function of a firms inventories of purchased materials and parts, of work
in process, and of finished products awaiting sale is to serve as buffers
absorbing the impact of short-run fluctuations in deliveries of inputs and in
demands for output. A firm may want its inventories to average out, over a
period of months or longer, to a stable level or into a stable relation with its
flows of inputs and output. Yet its inventories may vary over shorter periods.
A drop off in demand for its product may be a fluke, soon to be reversed. While
seeking further information on the market situation, the firm may well continue
producing output and even buying materials as before, letting its inventory of
unsold output grow. So doing, it avoids cutting the incomes of its suppliers and
employees and avoids the spread of recession on this account.
Of course, if production persists despite fallen demand long enough for inventories to rise clearly above a level felt tolerable, the firm will adjust production.
In the opposite direction, similarly, a firm may initially respond to a spurt in
sales by drawing down inventories. But if the spurt persists, it cannot maintain
that passive response.
The idea that firms may passively allow inventories to fluctuate within certain
ranges and will actively adjust production only when inventories move outside
them has given rise to a so-called corridor theory of economic fluctuations.
Within a supposed corridor on a time-series diagram of economic activity, the
buffer function of inventories tends to absorb shocks, especially as long as fluctuations remain sectorally localized. This buffer role of inventories puts a further
element of play and indefiniteness into the contagion of recession and recovery.
The income-constrained process does not operate with mechanical precision.
But the theory of that process does not become otiose.
Only when shocks are severe enough to push activity outside the corridor
do deviations become self-aggravating. (Anyway, this is the theory of Leijonhufvud, 1973 as interpreted by Blinder, 1981.) This is an intriguing but unproved
idea. It seems to ignore an opposite kind of corridor effect whereby cash
balances can resist the further worsening of substantial and pervasive fluctuations. A steady or moderately growing nominal money supply can have this
dampening effect. We have less reason to expect a monetary dampening of
merely minor or localized fluctuations because people will not act to maintain
a precise ratio between their incomes and their cash balances. The buffer role
of cash balances absorbing short-run or random spurts and slumps and mismatchings of receipts and payments accounts for a certain passiveness of
response to such fluctuations. A sustained and pervasive disturbance to income,
183
184
Monetary theory
in the case of excess demand, the curve indicates the amount of labor required
if the firm is to supply the indicated amount of commodities.
Real
output
A
Households
(solid)
E
Firms
Households
(dashed)
0
Full employment
Employment
Figure 6.2
In the excess supply case, the curve for households shows the demand for
commodities arising from specified amounts of actual employment. Here the
solid households curve shows how much labor would be offered if the indicated
amounts of commodities were available. Here the curve has a positive horizontal
intercept, suggesting that households would offer some labor, presumably to
accumulate buying power over commodities in the future, even if none were
currently available. (The diagram ignores the question of how workers could
supply any work without any current consumption. Perhaps the households
curve should be left undrawn in the vicinity of the horizontal axis.) The dashed
households curve is drawn for a real quantity of money sufficient for full
employment. It passes through point A, since households would provide
sufficient labor at full-employment output.
The contrasting positions of the solid curve for households in the two cases
reflect opposite monetary disorders real balances too small for fullemployment equilibrium in the earlier case, too large in this one. The curves
answer different questions: earlier, how much commodities would households
demand if they could obtain indicated volumes of employment?; here, how