American Economic Association Keynesian Models of Recession and Depression Author(s): James Tobin Source: The American Economic Review, Vol. 65, No. 2, Papers and Proceedings of the Eighty-seventh Annual Meeting of the American Economic Association (May, 1975), pp. 195-202 Published by: American Economic Association Stable URL: https://www.jstor.org/stable/1818852 Accessed: 23-06-2019 17:41 UTC JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected]. Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at https://about.jstor.org/terms American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review This content downloaded from 189.6.25.92 on Sun, 23 Jun 2019 17:41:06 UTC All use subject to https://about.jstor.org/terms Keynesian Models of Recession and Depression By JAmES TOBIN* Keynes's General Theory attempted to days and I shall not dwell on this point prove the existence of equilibrium with in- here. (See, however, A. S. Blinder and voluntary unemployment, and this pre- R. M. Solow and J. Tobin and W. Buiter.) tension touched off a long theoretical The second important point, the one on controversy. A. C. Pigou, in particular, which Pigou insisted, is that excess supply argued effectively that there could not be a of labor must cause money wages to de- long-run equilibrium with excess supply of cline. Even if this did not succeed in elimi- labor. The predominant verdict of history nating unemployment, one might not call is that, as a matter of pure theory, Keynes a situation in which money wages and failed to prove his case. prices are persistently falling an equi- Very likely Keynes chose the wrong librium. But of course Pigou went further battleground. Equilibrium analysis and in contesting Keynes's claim that a "trap" comparative statics were the tools to might exist from which the economy could which he naturally turned to express his not be rescued, however low the wage and ideas, but they were probably not the best price level. tools for his purpose. For one thing, he ex- Keynes tried to make a double argument plicitly confined the General Theory to a about wage reduction and employment. time period in which are given "the exist- One was that wage rates were very slow to ing skill and quantity of available labor, decline in the face of excess supply. The quality and quantity of available equip- other was that, even if they declined faster, ment, the existing technique" and other employment would not-in depression cir- factors. As he said (p. 245), "in this place cumstances-increase. As to the second and context, we are not considering or point, he was well aware of the dynamic taking into account the effects and conse- argument that declining money wage rates quences of changes in them." But his are unfavorable to aggregate demand.' model produces a solution in which, in But perhaps he did not insist upon it general, the stock of capital, and other strongly enough, for the subsequent theo- stocks, are not constant. Changes in these retical argument focused on the statics of stocks will in turn alter investment, saving, alternative stable wage levels. and other behavior. For this reason alone, The real issue is not the existence of a the solution of Keynes's model cannot be 1 s... it would be much better that wages should be stationary, even in its own endogenous rigidly fixed and deemed incapable of material changes, variables; and on this ground alone, it fails than that depression should be accompanied by a gradual downward tendency of money-wages, a further to qualify as an equilibrium. The evolution moderate wage reduction being expected to signalise of Keynesian equilibrium as stocks change each increase of, say, 1 percent in the amount of un- is receiving a great deal of attention these employment. For example, the effect of an expectation that wages are going to sag by, say, 2 percent in the * Sterling Professor of Economics, Yale University. coming year will be roughly equivalent to the effect of a The research described in this paper was undertaken byrise of 2 percent in the amount of interest payable for grants from the National Science Foundation and the the same period. The same observations apply mittatis Ford Foundation. muitandis to the case of a boom." (See Keynes, p. 265.) 195 This content downloaded from 189.6.25.92 on Sun, 23 Jun 2019 17:41:06 UTC All use subject to https://about.jstor.org/terms 196 AMERICAN ECONOMIC ASSOCIATION MAY 1975 long-run static equilibrium with unemploy- that Keynes was a "Marshallian in meth- ment, but the possibility of protracted un- od" and translated the supply-demand employment which the natural adjust- framework of Alfred Marshall from indi- ments of a market economy remedy very vidual markets to the whole economy. slowly if at all. So what if, within the "Where he deviated from Marshall, and it recherche rules of the contest, Keynes was a momentous deviation, was in re- failed to establish an "underemployment versing the roles assigned to price and equilibrium"? The phenomena he de- quantity. He assumed that, at least for scribed are better regarded as disequilib- changes in aggregate demand, quantity rium dynamics. Keynes's comparative was the variable that adjusted rapidly, statics were an awkward analytical lan- while price was the variable that adjusted guage unequal to the shrewd observations slowly, at least in a downward direction." and intuitions he was trying to embodly. Friedman is correct that this was a mo- If the purity of neoclassical equilibrium is mentous deviation, and one way to appre- preserved, this verdict is no real blow to ciate the point is to look explicitly at the Keynes or solace for Pigou. The Great dynamic stability implications of XVal- Depression is the Great Depression, the rasian vs. Marshallian assumptions about notorious "Treasury View" is still ridicu- quantity adjustment. lous, whether mass unemployment is a fea- Marshallian adjustment in a particular ture of an equilibrium or of a prolonged market is that quantity adjusts to the dif- disequilibrium. ference between demand price and supply The issue is by no means dead. Today price for existing quantity. Walrasian ad- "full employment" has become the "natu- justment is that quantity adjusts to the ral rate," and "equilibrium" often allows difference between demand and supply at for any steady rate of deflation or inflation, existing price. not just zero. But the proposition which Let us now apply these two adjustment Keynes was questioning is once again assumptions to a simple macroeconomic strongly argued in the profession and in model. Let Y be aggregate real output, public debate. Once again it is alleged that and Y* its value at full employment, i.e., the private market economy can and will, at the "natural rate" level of unemploy- without aid from government policy, steer ment. Let E be aggregate real effective itself to full employment equilibrium. This demand, which can differ in short-run dis- is the basis for advocacy of fixed rules of equilibrium both from Y and from Y*. monetary growth and fiscal policy, as Given the nominal stock of outside money against active discretionary policy re- M and other exogenous or policy-set vari- sponding to information fed back from the ables, effective demand E is a function private economy. At this very moment it E(p, x, Y) of three variables: p the price is the basis for a policy of letting the re- level, x its expected rate of change, and Y cession run its course, in confidence that in the level of output and real income. a relatively short run-two or three In finer detail, E is the sum of consump- years equilibrium will be restored at full tion C, private investment I, and govern- employment with reduced or even zero ment purchases G: inflation. I. Keynesian and Marshallian (1) E-=C (Y, Y1*, -T, -R) GW Price Dynamics Milton Friedman (p. 18) has pointed out + I(Yj Y*, -KY -R) + G This content downloaded from 189.6.25.92 on Sun, 23 Jun 2019 17:41:06 UTC All use subject to https://about.jstor.org/terms VOL. 65 NO. 2 KEYNESIAN MODEL 197 Here the C and I functions have positive run are private debts in the unit of ac- derivatives in all their arguments. T repre- count. These are a heavier burden to sents taxes, a function of Y and Y*. W is debtors the lower the price level, and there private wealth, equal to are good reasons why transfer of real in- come and wealth to creditors spells a net M -+ qK, deficit of aggregate demand. Debtors are p debtors because they have high propensi- where the coefficient q is the ratio of ties to spend. Many of them are liquidity- market valuation of capital equity to re- constrained, and as their debt/equity placement cost. An increase in the real ratios increase their credit lines dwindle or, interest rate R relative to the marginal in case of bankruptcies, disappear. Al- efficiency of capital makes q fall, and though these are "only" distributional makes investment fall. The marginal effi- effects, they may be more important than ciency of capital depends positively on Y the real value of outside money and debt.