The Tendency towards Full Employment in the Neoclassical Synthesis
The neoclassical synthesis (the IS-LM model) re-established the pre-Keynesian idea that in a market economy with flexible money wages and prices endogenous mechanisms exist which establish a long-run tendency towards full employment: Keynesian outcomes are therefore a special case.
This overturn of Keynes’s conclusion, however, was achieved while apparently retaining his contribution in the theory of output and interest rate. This was accomplished by emphasizing the effect of wage and price deflation on the equilibrium interest rate, and of the latter on aggregate investment. The warnings about the negative effects of deflation were disregarded, and though obstacles to wage flexibility were largely recognized, the argument re-established in principle the self-adjusting nature of the economic system, while at the same time it was argued that in practice appropriate monetary policy would normally allow keeping the economy close to full employment. Such greater reliance on monetary policy than had been suggested by Keynes was itself linked to a different approach to the analysis of money demand and the determination of the interest rate. While Keynes’s perspective had been “speculative” in the sense that he regarded the attitude towards the demand for money as a financial asset as mainly determined by expectations and the search for capital gains, the neoclassical synthesis regards the demand for money as part of a portfolio choice based on an evaluation of risks and returns, thus giving rise to much smoother changes and, at least in the long run, to the possibility for the central bank to control the interest rate and hence bring aggregate investments in line with full employment savings. More recently, increasing emphasis has been placed on the role of the so-called “real balance effect”, that is, on the role of an increase in real money balances (following upon a fall in nominal wages and prices) in stimulating private consumption via an increase in the propensity to consume. Such increased emphasis may have been the result of growing uncertainty, on both empirical and theoretical grounds, over the effects of the interest rate on aggregate investments. Yet it is to be doubted that the real balance effect can, by itself, provide an endogenous mechanism leading to full employment, as recognized even by Patinkin (1987), one of the economists who contributed most to developing the analysis of such effect. In addition, money wage and price deflation may have serious adverse effects on aggregate demand by routes already suggested by Keynes in chapter 19 of The General Theory, among which is the increase of the debt burden, which may lead to defaults on the part of firms and households and, as a consequence, of banks.Thus, it can be seen that at the basis of the neoclassical synthesis lies, on the one hand, a reference to those Marshallian elements, namely, the decreasing demand curves for labour and investment that Keynes did not criticize (and in fact could not at the time, since critical arguments concerning those theoretical foundations had not yet been developed). On the other hand, there are the inner contradictions of the General Theory between the objective of formulating a long-run, general theory of employment, and the short-run nature of some of the arguments put forward to maintain that the interest rate could not easily be established at the level consistent with full employment (Garegnani 1978-79).