Working Paper No. 236 | May 1998

An Important Inconsistency at the Heart of the Standard Macroeconomic Model

The standard neoclassical model is the foundation of most mainstream macroeconomics. Its basic structure dominates the analyis of macroeconomic phenomena, the teaching of the subject, and even the formation of economic policy. And, of course, the modern quantity theory of money and its attendant monetarist prescriptions are grounded in the model's strict separation between real and nominal variables. It is quite curious, therefore, to discover that this model contains an inconsistency in its treatment of the distribution of income. And when this seemingly small discrepancy is corrected, without any change in all of the other assumptions, many of the model's characteristic results disappear.

Two instances are of particular interest. First, the strict dichotomy between real variables and nominal variables breaks down, so that, for example, an increase in the exogenously given money supply changes real variables such as household income, consumption, investment, the interest rate, and hence real money demand. Secondly, since the price level depends on the interaction of real money demand and the nominal money supply, and since the former is now affected by the latter, price changes are no longer proportional to changes in the money supply. Indeed, we will demonstrate that prices can even fall when the money supply rises. The link to the quantity theory of money, and to monetarism, is severed.

Associated Program:
Wynne Godley Anwar M. Shaikh

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