The Neoclassical-Keynesian
Synthesis
Real Balance Effects and the Neoclassical Response
to Keynes
The Neoclassical Response to the Keynesian Critique
1.
2.
3.
Some neoclassical economists became Keynesians
Some tried to ignore Keynes
Some misinterpreted Keynes as arguing that sticky
wages and prices could cause unemployment in the
long run (this result was already in neoclassical
economics—if that is all that Keynes was arguing,
then Keynes was not making a new contribution).
Neoclassical Response to Keynes
4. This next response was the most interesting: it said, “Keynes
is making some real contributions and we should recognize
that. His theory of the multiplier, his argument that we
should conduct aggregate analysis and that money should play
a central, determining role, even his liquidity preference
theory, are all real contributions and should be incorporated
into the analysis.”
Response to Keynes
 “But,” this response continued, “if Keynes is saying he is
refuting neoclassical theory he is going too far.” “Because,”
they said, “it can be shown that all of these contributions can
be incorporated into the broader neoclassical framework and
it can still be demonstrated that the central proposition of
neoclassical macro theory still holds.”
Central Proposition of Neoclassical Macro
 They argued: “It can still be shown that if wages, prices, and
interest rates are perfectly flexible that the economy will
tend to full employment in the long run.”
 The argument will look a little different, it won’t be simply
the old neoclassical labor and loanable funds markets story.
Grand Neoclassical-Keynesian Synthesis
 This argument, which came to be known as the neoclassical
synthesis, used the real balance effects arguments to
demonstrate their proposition.
 The real balance effects has two parts: the direct real balance
effect, or Pigou effect, and the indirect real balance effect, or
Keynes effect, or interest rate effect.
Real Balance Effects
 The real balance effect argument begins by noting that in
Keynes if there is unemployment, or aggregate supply is
greater than aggregate demand, firms will cut back
production, income will fall, and employment will fall.
 But, they ask, what if instead of cutting output, firms cut
prices in response to insufficient demand? And if this
occurred throughout the economy, the price level would
fall (there would be deflation). Deflation means that the
real value of money would rise.
Direct Real Balance (or Pigou) Effect
AS>AD  P ↓  real value of $ ↑  (C + I)↑  mult effects 
Y↑ Yf
When AS>AD, the price level falls, increasing the real value of
money. Consumers and investors holding cash would feel richer,
and consumption and investment would rise. This would set off
multiplier effects, increasing output and income. As long as
AS>AD, this would continue, until full employment.
Indirect Real Balance (or Keynes or Interest Rate) Effect
AS>AD  P ↓  real value of $ ↑  amount of $ necessary to satisfy
transactions demand for $↓  amount of $ available for speculative
demand↑  demand for securities↑  bond prices↑  interest rates↓
 (C + I)↑  mult Y↑ Yf
Demand for Money in Keynes
Keynes asked the question: “Why would anyone hold any of
their wealth in the form of cash rather than in higher
interest-earning or profit-bearing assets?”
He gave three reasons in The General Theory: transactions
demand for cash, precautionary demand for cash and the
speculative demand for cash.
Demand for Money
Transactions demand – wealth people keep in the form of cash
to make normal daily, weekly, and monthly transactions.
Precautionary demand – in case of emergencies (flat tire,
broken arm, etc.)
Speculative demand – in case an unexpected financial
opportunity should arise, to earn higher than normal profits.
Inverse relation between bond prices and interest rates
Suppose a bond that sells for $1000 earns $50 per year interest.
So the interest rate is 5%. Then suppose the interest rate
rises to 10%. The bond is locked in to a return of $50 per
year, so the price falls to $500. (think of the alternative of
putting $1000 in the bank at 10%, it would earn $100, so no
one would buy the bond for $1000 when the return is $50 if
the interest rate is 10%.).
Real balance effects and neoclassical synthesis
 Notice that the RBE incorporate aggregate analysis, money as
a central determining variable, the multiplier, and liquidity
preference theory all from Keynes.
 Yet the central proposition of neoclassical macro still holds—
if wages, prices, and interest rates are perfectly flexible, the
economy tends to full employment in the long run, no
government intervention.
Keynesian reply to RBE
1. yes, if price level falls, real value of $ rises, but what about
the real value of non-cash assets? So, whether you feel richer
or poorer when there is deflation depends on whether
households and businesses keep their wealth in cash or noncash assets.
Keynesian reply to RBE
2. yes, if price level falls, real value of $ rises, but what about
the real value of debt? Debt is denominated in cash, so real
value goes up when price level falls. Whether households and
businesses feel richer or poorer when there is deflation
depends on the importance of debt (consumer debt,
corporate debt, and government debt as well).
Keynesian reply to RBE
3. Consideration of expectations complicates the RBE stories. If
consumers and investors do not know if prices and interest rates
will continue to fall, they may not buy (and borrow to buy), but
wait and see if they fall more. And if they do not buy (and
borrow), then prices and interest rates continue to fall. How
high will the real value of debt inflate before they think prices
and interest rates have hit rock bottom?
Keynesian reply to RBE
4. Lower prices may be good for buyers, but are they good for
sellers? It depends. If you are thinking about investing in
producing widgets because interest rates are down, and you
see the prices of widgets falling, there is a limit to how low
prices can go before it is a dis-incentive for you to expand
output in that market.
Keynesian reply to RBE
5. Indirect real balance effect reintroduces the mechanistic
inverse relation between interest rates and investment that
Keynes criticized. (this applies only to the indirect real
balance effect).
Keynesian reply to RBE
6. Historical experience and empirical record
a. Great Depression – deflation, but no real balance effects.
Interest rates zero, no investment.
b. Post WWII experience of industrialized nations. Many
periods of unemployment, but virtually no deflation.
(slowing of inflation not the same as deflation)