Keynesian Economics and Price Theory

Price theory in a monetary economy is outlined in this chapter. Prices are considered to equalize demand and supply in a barter economy. However, the function of price changes entirely in a monetary economy. As is evident from daily life, the value of money (the inverse of the price index) is determined by rational belief concerning its future value in itself. If individuals confirm the future devaluation of money, this immediately raises the current price level. In turn, if they are confident about the value of money, the price level becomes stable. However, goods markets are adjusted not by price but by quantity. Thus, when monetary theory is recognized to have intrinsic dynamic properties, quantity adjustment such as the multiplier process emerges consistently with neoclassical microeconomic theory. In addition, the theory outlined in this chapter contains the quantity theory of money as an extraneous rational belief under conditions of market equilibrium.

This chapter proves the existence of involuntary unemployment not otherwise caused by the monopsony of incumbent employees. The efficient bargaining model developed by McDonald and Solow plays an important role. Their theory depicted wage bargaining as Pareto-efficient allocations concerning the real wage and the employment level. However, such a negotiation structure presumes that the bargaining game is a simultaneous move. This assumption implies that even unemployed workers agree with the result. In this sense, unemployment is voluntary in that theory. The model in this chapter decomposes the negotiation process into a two-stage game. At the first stage, an employer decides the employment/output level. Given that result, employer and employees negotiate the nominal wage in a second stage. Given that the best response for the employer is to produce as many goods as possible, when the result of this second-stage game and the equilibrium nominal wage exceed the reservation level, unemployment is involuntary in the sense of Keynes.

This chapter extends the fundamental theory described in Chap. 2 by permitting that labor productivity varies in conjunction with the unemployment rate. It is assumed that a higher unemployment rate aggravates future labor productivity because unemployment curtails households’ income for educating their children. Stagnation in labor productivity triggers disinflation. This is because the unit cost of production becomes expensive relative to an arbitrarily given future price. Thus, there emerges a negative causality between the unemployment rate and the inflation rate even though ad-hoc assumptions concerning price stickiness are excluded.

This chapter constructs a basic model of a flexible exchange rate system and considers the international diffusion of business cycle on the basis of a rigorous dynamic microeconomic foundation. The seminal work of Laursen and Metzler (1950) suggests that the employment isolation effect under a flexible exchange rate system is imperfect even if international capital mobility is completely prohibited. Assuming a small country model instead of the two-country model of Laursen and Metzler (1950), the following results are obtained: (i) the business fluctuations in the world economy diffuse to a small country through changes in the inflation rate that result from changes in real exchange rates. In this sense, the employment isolation is imperfect; and (ii) domestic monetary expansion has a weaker effect than in the Mundell (1963) or Fleming (1962) models. This is because monetary expansion, which always accompanies fiscal expansion, raises current domestic prices and lowers the inflation rate as long as the purchasing power of money (the inverse of future price) is kept intact. Such disinflation reduces consumption demand despite the expansionary multiplier effect.

Some previous studies assert that the selection of a key currency is a kind of hysteresis dominated by contingencies. However, historical evidence suggests that this selection depends on the two plausible and inevitable economic factors that this study examines: overwhelming industrial power and the possession of large amounts of foreign assets and gold. Based on the acquisition of these economic factors, a key-currency country receives rents in return for bearing the sovereign risk and supplying sufficient liquidity to countries within its network that accept its currency. Thus, the key-currency system can be regarded as an international liquidity provision and insurance system that relies on the economic power of the key-currency country.

This chapter provides a microeconomic foundation for Mundell’s optimum currency area theory. The model considers twin countries where labor forces are fixed to each country even though real capital moves internationally. When the central bank in each country behaves non-cooperatively, it will raise the domestic interest rate to attract more real capital and increase the rent of residences. However, fierce competition between central banks ultimately exacerbates disparities in income distribution. Moreover, when real capital does not have a nationality, a worsened income distribution also results in inefficient resource allocation. Thus, twinned countries should unify their central banks and coordinate their monetary and interest policies. In other words, these countries constitute an optimum currency area.

This chapter considers under what conditions a regionally fixed exchange rate system without a huge economy is sustainable. The Eurozone is a typical example. In general, the Eurozone tends to be regarded as a currency area. However, the political power of the European Central Bank is not strong enough to control the fiscal and monetary policies of each affiliate country directly. That is, the unification of central banks within the area is not complete, and the Eurozone is therefore not a currency area in the sense of Mundell. It should be regarded as a regional fixed exchange rate system. An open economy Keynesian model under a fixed exchange rate system with a dynamic microeconomic foundation is constructed. The following results were obtained. First, whenever a government’s tax-levying ability is limited, austere fiscal policies are required to sustain the system. Second, low tax-levying ability has a negative effect on the economic welfare of a country because such fragility limits its discretionary monetary policy.

This chapter considers the welfare implications of foreign direct investment (FDI) under a flexible exchange rate system, from the viewpoint of a macroeconomic theory. With FDI there can be a conflict between individual firms and the national economy as a whole. Although lower wages may be an incentive for firms to take advantage of FDI, the resulting economic surge may harm the national economy. This comes about first because an increase in unemployment in the home country will reduce that economy’s welfare, and second, an appreciation in the real exchange rate, caused by the remittance of earnings from foreign countries, will reduce the value of profits in terms of domestic goods. This appreciation entirely cancels the benefit from the cost reductions that induce FDI in lower-wage countries, and only the downturn in employment remains. In this sense, a glut in FDI is harmful, and some coordination is required between firms and their government to reduce its effects.

Determining which production resources embody business skills is a very important issue, not only for investment function theory but for the theory of the firm. Uzawa regards these nurtured skills as being entirely attributable to real capital and establishes a microeconomic foundation for Tobin’s q theory. However, how skills are embodied in real capital in the Tobin–Uzawa theory is quite ambiguous. It seems natural that such skills are acquired by employees through learning by doing as proposed by Arrow, and/or formal education within a firm. Thus, labor is dealt with here as a quasi-fixed production resource instead of as real capital. The objective function of a firm is set as the discounted sum of the surplus from skilled employees, and this solves the optimal path of accumulation of intangible skills. The following results are obtained: first, human-capital q theory that emphasizes the importance of internalization of the positive externality from skilled labor force to real capital is established. This externality is termed the dexterity of employees; and second, the case where an employer regards the firm as a standard neoclassical type is considered. In such a case, since the contribution of dexterity is neglected, the employer recognizes that the production function is not one of constant return, but gives decreasing returns to scale. As a result, the equilibrium growth rate of such a firm becomes zero in the long run. This finding implies that to sustain the growth of a firm it is crucial to evaluate the dexterity of employees correctly.

This chapter analyzes the properties of Keynesian monetary economic growth theory under perfect competition. Whether capital investment is constrained by effective demand is a critical factor that characterizes economic growth theories at different levels of competition. Whenever a firm faces a downward-sloping demand curve at a location determined by the strength of effective demand (real GDP), its capital accumulation is inevitably constrained by effective demand. Thus, as far as the business environment is kept unchanged, so is capital investment. However, when the market for goods is perfectly competitive, firms do not perceive such demand constraint, and capital investment advances autonomously and is independent of that phase of the business cycle. An important macroeconomic implication of the Keynesian growth model under perfect competition is the crowding out of assets, which means that an increase in money requires a higher rate of return (i.e. the inverse of the inflation rate) to equilibrate the market, and thus incurs higher opportunity cost to capital investment. This curtails capital investment and retards economic growth.

Almost every developed country experiences serious enlargement of the scale of government, specifically in the expansion of fiscal deficits. This chapter outlines why such a phenomenon is so prominent, based on a Keynesian growth model entirely compatible with standard neoclassical microeconomics. Cost-minimizing investment plays a key role. Whenever the demand that each firm faces is constraint by effective demand (cases include the situation of monopolistic competition), a firm strives to raise the productivity of labor and save its production costs. Since such a process continues only until costs are completely minimized, human capital investment is gradually reduced as the improvement in the production process advances. Thus, this form of investment cannot become a driving force for economic growth. As a result, and differing from the case for perfect competition analyzed in Chap. 12, ceaseless expansionary aggregate demand policy is inevitably required when seeking sustainable economic growth under monopolistic competition.

Lucas’ theory contains two theoretical problems that are not yet solved. One is whether he succeeds in deriving the objective cumulative density function (CDF) from an arbitrarily given subjective CDF. In this section it is shown that this question must be answered in the negative. Further, even though an individual can directly collect noisy information concerning the true state of an economy and not through the equilibrium price, it is still debatable whether the simplified signal extraction problem is precisely formatted in his model. It is shown here that this procedure is also imprecise, and that it is necessary to provide an additional condition that completes the existence proof.

In this chapter, the question of whether the theories of Kiyotaki and Wright substantially contributed to the development of a new monetary theory in the vein of search theory is discussed. The following observations can be made: (i) Kiyotaki and Wright succeed in proving that the circulation of money improves economic welfare. However, this contribution is nothing more than that of the overlapping generations model developed by Samuelson and Lucas; and (ii) the equilibrium of a barter economy remains in the Kiyotaki and Wright model, which is an extension of the Diamond model. Based on this analysis, the present exercise rigorously proves that money never circulates in their model.