Keynes Pigous Effect
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Transcript of Keynes Pigous Effect
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BEN L KYER
Francis Marion College
Florence, South Carolina
GARY E. MAGGS
St. John Fisher College
Rochester, New York
On the Keynes and Pigou E&c& in
Aggregate Demand Theory*
The standard approach to the derivation of aggregate demand employs the IS-LM
model with a flexible price level in which distinctions are drawn between the Keynes
and Pig ou effects. This paper is an extension of this traditi onal analysis and dem-
onstrates that the slope of the economys aggregate dema nd function may be di-
chotomized and specified as the summ ation of these two effects. This result is then
used to examine the impact of different conditions within the product and money
markets. An expression for the price level elasticity of aggregate dema nd is also
derived.
1. Introduction
The theory of aggregate demand occupies a position of im-
portance in macroeconomics. In many textbooks, at both the inter-
mediate and graduate levels, demand-side equilibrium is derived
and examined via a price-flexible IS-LM framework. As part of this
examination, a distinction is regularly made between the Keynes
and Pigou effects in order to differentiate between the impact of a
change in the general price level on the money and product mar-
kets.
A re-examination of this analys is indicates that the Keynes and
Pigou effects are additively separable in the specification of the
economys aggregate demand function. This proposition is implicit
in the standard derivation of aggregate demand and, to our knowl-
edge, has not been direct ly shown previously. r The purpose of this
*The authors gratefully acknowledg e the assistance of two anonymous referees
who provided useful suggestions on an earlier draft of this paper.
This assertion is mad e follo wing a survey of a number of macroeconomics text-
books. These include texts by Bail ey (1971); Branson (1989); Cordon (1990); Hall
and Taylor (1991); Sargent (1979); Barron (1989); Dembe rg (1989); Froyen (1999);
Ott, Ott, and Yoo (1983); and Peterson.
Journal
of
Macroeconomics, Spring
1992, Vol. 14, No. 2, pp. 371-375 371
Copyright 0 1992 by Louisi ana State University Press
0164-0794/92/ 1.50
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Ben L. Kyer and Gary E. Maggs
paper, therefore, is to demonstrate that the total effect of a change
in the general price leve l on the equilibrium quantity of real output
demanded can be decomposed and stated as the sum of the indi-
vidual Keynes and Pigou effects. With this result we show the spe-
cif ic conditions under which either of these two effects would be
lessened or cease to exist, and derive an expression for the price
level elastic ity of aggregate demand.
2. The Analysis
We begin by specifying a basic two-sector closed economy
without government. Real saving (s) is assumed to depend on both
real income (y) and real assets (A/P), while real investment (i) is
expressed as a function of the market interest rate (r). Nominal as-
sets (A) equal the sum of narrow money balances (M) and bonds
(B), and (P) is the general price level. These assumptions allow
expression of the product market equilibrium condition as
s(y, A/P) = i(r) .
0)
In the money market, the demand for real balances m( ) is a
function of real income and the interest rate with equlibrium in this
market expressed as
M
- = m(y, d ,
P
(2)
where M is the nominal supply of money.
The derivation of the macroeconomic demand curve begins by
totally differentiating Equations (1) and (2) to arrive at
s,dy + sA,p(pdp) = i,dr
and
PdM - MdP
P2
= m,dy + m,dr ,
(3)
(4)
Exclusion of the government sector is for mathe matic al simplicity. To includ e
the foreign sector wou ld be to introduce a foreign trade effect into the analysis.
The results of the mod el are robust with extensions into either the public or foreign
sector.
372
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Ben L. Kyer and Gary E. Maggs
which shows that the only price-induced effect on equilibrium out-
put occurs in this case through changes in real saving.5
An interesting extension of the above analysis is to rewrite
Equation (5) in elasticit
dv P
1
--=
&, y EY.p jj
I.
7)
Equation (7) is the point elastic ity of aggregate demand with respect
to a change in the general price level. The impact of changes in
aggregate supply on nominal GNP will depend on the elast icity of
aggregate demand. For instance, an inelastic aggregate demand im-
plies that an increase in aggregate supply would decrease nominal
GNP since the resulting deflation would be accompanied by a pro-
portionately smaller increase in real output.6 The ultimate effects
of external supply shocks on the price and real output levels may
also be traced with this elasticity. In general, Equation (7) provides
a manageable framework with which to analyze economic growth
that results from the behavior of aggregate supply.
3. Conclusion
A thorough understanding of demand-side equilibrium is es-
sential in macroeconomics. While the traditional derivation of ag-
gregate demand via the Keynes and Pigou effects is worthwhile,
the approach may be improved by providing a more unified treat-
ment. The purpose of our paper has been to provide one such pro-
cedure. In short, we have shown that aggregate demand changes
can be expressed as the sum of the Keynes and Pigou effects, a
result which seems significant for several reasons. Firs t, Equation
(5) reveals the functional relationship between the slope of the ag-
gregate demand curve and the Keynes and Pigou effects when both
are included in its derivation. This additive result is a logical ex-
5Eq uatio n (5) may similarly be used to demonstrate that the Keynes effect is
also zero when i, = 0, and that the P igou effect is zero when i, + m or nt, = 0.
Whether aggregate dem and is actually elastic or inelastic with respect to the
price level is, of course, an empiric al question. Future research of the authors wi ll
focus on this issue.
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On the Keynes and Pigou Effects in Aggregate Demand Theory
tension of the standard method used in modeling aggregate demand
in macroeconomic theory.
Second, our analytical framework is sufficiently flexible to ex-
amine aggregate demand under various abnormal macroeconomic
settings, such as the theoretical liquidity trap. This flexib ility we
have found beneficia l in teaching aggregate demand theory in mac-
roeconomics. Finally, we have shown that an expression for the price
level elasticity of aggregate demand is easily derived when the slope
of the aggregate demand function is expressed in terms of the sep-
arated Keynes and Pigou effects. Although this elastic ity is largely
ignored in the macroeconomic literature, its value is important in
determining the extent to which variations in aggregate supply con-
tribute to changes in the economys real output and price levels.
Received: October 1990
Fina l version: May 1991
References
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