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Monetary theory

Real
output
A
Households
(dashed)

Households
(solid)

Firms

Full employment
Employment

Figure 6.1

The case of deficient demand

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

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(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.

MONETARY EXPANSION IN A RECESSION


Suppose that something, perhaps a fall in the money supply, has already caused
a recession. Now the nominal money supply expands sufficiently. A depressed
level of activity is no longer needed to choke off the effective excess demand
for money that caused the recession. People no longer feel pressed to curtail their
buying to restore or conserve cash. They feel freer to spend. Restoring full
activity does not necessarily require a fall in the real wage rate. The demand for
labor increases as producers find that they can sell more output. Barro and
Grossman even suggest that the recovery of output and employment may be
accompanied by a rising real wage. This procyclical change differs from the
conventional view that employment and real wages must be inversely related
(1971, p. 87). The conventional view at the time, as expressed in Friedmans
seminal 1967 address to the American Economic Association, was that a lower
actual real wage was necessary to convince producers to increase output.
Workers would agree to supply more labor because they misperceived the real
wage (see pages 206208 below).
The case of recovery from recession is again portrayed in Figure 6.1. Now,
though, the increase in the money supply shifts the curve for households upward,
so the relevant curve is the dashed line. Point A represents the new equilibrium
at full employment.

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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,

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183

however, would disrupt income/money ratios enough to elicit the response


described in Chapters 3 and 4.

MONETARY EXPANSION AND A CONCEIVABLE FALL


IN OUTPUT
An increase in the money supply at full employment could bring either of two
results. In the case we take up second, output rises temporarily.
First, though, we consider the model of Barro and Grossman, which assumes
that firms do not hold inventories and that wages and prices are rigid or sticky
both upwards and downwards. In their model, a general excess of aggregate
demand (and not only a general deficiency) could impair real activity.
From full-employment equilibrium, the money supply expands, causing
general excess demand. The individual household now meets frustration trying
to buy the commodities that it notionally demands. Accordingly, it reduces its
effective supply of labor below its notional supply. (Why keep on working full
time to earn income and acquire money when one already meets frustration
spending it?) The reduced effective supply of labor constrains actual
employment and makes output fall further short of demand. In this model,
monetary disorder excess as well as deficiency disrupts exchanges and so
restricts employment and production.
When the average household is unable to buy all the commodities that it
notionally demands, does it fully substitute leisure for the unavailable consumption? Most likely it compromises between two responses, effectively
supplying less labor and effectively accepting more real money balances. The
latter implies a greater than notional effective demand for future consumption.
Cash balances are the only vehicle of saving in the model.
The average firm perceives a supply-imposed constraint on its employment
of labor, which not only reduces its profits but also causes it to reduce its actual
output. This induced reduction in output further constrains consumption, which
induces a further reduction in effective labor supply. (On the other hand, the
induced reduction in profits distributed to households creates a partially
offsetting stimulus to effective labor supply.) A cumulative decline persists
until the actual levels of output and employment settle below their fullemployment levels.
Figure 6.2 portrays this case of general excess demand. The 0A curve is the
same as in Figure 6.1, reflecting the production function of firms. The interpretations, however, require different emphases. In the excess supply (of
commodities) case of Figure 6.1, the 0A curve indicates the commodity demand
necessary to motivate firms to offer the indicated amount of employment. Here,

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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

The case of excess demand

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