keynes pigous effect

8/9/2019 Keynes Pigous Effect

1/5

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


2/5

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


3/5


4/5

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.

374


5/5

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

Bailey, Martin J. National income and the Price Level: A Study in

Macroeconomic Theory. 2d. ed. New York: McGraw-Hill, 1971.

Barron, John M., Mark A. Lowenstein, and Gerald J. Lynch. Mac-

roeconomics.

Reading, Massachusetts: Addision-Wesley, 1989.

Branson, William H. Macroeconomic Theory and Policy. 3d ed. New

York: Harper and Row, 1989.

Dernberg, Thomas F.

Global Macroeconomics. New

York: Harper

and Row, 1989.

Froyen, Richard T. Macroeconomics: Theories and Policies. 3d ed.

New York: Macmillan Publishing Co., 1996.

Gordon, Robert J. Macroeconomics. 5th ed. Glenview, Illinois: Scott,

Foresman/Little Brown, 1996.

Hall, Robert E., and John B. Taylor.

Macroeconomics: Theory, Per-

formance, and Policy. 3d ed. New York: W. W. Norton, 1991.

Ott, David J., Attiat F. Ott, and Jang H. Yoo. Macroeconomic The-

ory. Lanham, Maryland: University Press of America, 1983.

Peterson, Wallace C. Income, Employment, and Economic Growth.

6th ed. New York: W. W. Norton, 1988.

Sargent, Thomas J. Macroeconomic Theory. New York: Academic

Press, 1979.

375

keynes pigous effect

Documents