However, Keynesians believe that the economy is not working under full employment. They argue that price flexibility is independent of full employment and that the economy is not on the full employment line, thus the labour market is not in equilibrium. Without an increase in the price level, the supply of output can be increased seeing as some workers and machines are unemployed and idle. Since prices are fixed, an increase in AE in the short-run will not increase price level but will increase output level (Backus et al., 1998). This illustration can be shown by a horizontal AS in the diagram on the next page:
AS is sticky at a particular given price level as output is determined by demand- therefore an increase in AD will not affect the prices in the short run but it will cause output to rise from Y1 to Y2 but the price level will remain at P. Hence, they disfavour the assumption of money neutrality as they believe that price is sticky and does not adjust quickly enough to counterbalance changes in money supply.
In addition, according to the Keynesians, in the short-run, prices are not flexible as they do not clear the market. For example, companies do not change the prices of their products they sell frequently- the financial times do not change their prices due to the level of demand or cost of production.
Moreover, full employment (Y) is reached after price and wage adjust so that labour supplied is equal to labour demanded. Below, a general equilibrium of the ISLM model can be seen:
The general equilibrium is represented by E, at the point of intersection. LM shifts because of adjustments of the price level until it passes through the intersection of the IS curve and the FE line. The full employment line is vertical. Y is the level of output which is supplied by firms when prices have adjusted fully, so hence, employment is at its full level.
In addition to the above, the affect of price flexibility on LM curve can be seen on the next page:
In order to reduce full employment output from Y1 to Y2 and to shift FE line to the left from FE1 to FE2, a temporary adverse shock must occur because “N is reduced by the supply shock which lowers the amount of output that can be produced”. FE2 becomes the new equilibrium as it is where intersection occurs but the IS curve remains unchanged (temporary adverse shock to the IS curve is movement along the curve, not a shift, so therefore, the IS curve is unchanged). The LM curve shifts up and to the left from LM1 to LM2 until it passes through E as a result of price level increase, thus as can be seen from the diagram above, price level is higher (Abel, 2001). This in turn, changes the real money supply, M/P. If price levels are flexible downwards, then the LM curve shifts downwards, to the right; this increases the real money supply, reduces interest rates and increases aggregate demand and investment. This is known as the Keynes effect.
The Keynes effect had some limitation; the economy could not lead back to full employment. As can be seen in the diagram A, below, the IS curve is vertical and the decrease in interest rate does not increase income or investment even though there is a rightward shift from LM1 to LM2. In diagram B, to the right of the IS curve is the full employment level of income on the horizontal axis which would imply that to restore full employment, there has to be a rightward shift of the LM curve, leaving the interest rate negative which is not possible (Cobham, 1987).
Diagram A Diagram B.
(Cobham,1987)
The Keynes effect was also criticised by Don Patinkin, Pigou effect who stated that there could be unemployment equilibrium because flexible prices may lead to an increase in the value of money balances and the falling of prices so therefore people will start saving less and their consumption will rise.
This analysis of the full employment with relation to ISLM model helped account for Japan’s recent slump. Japan went into recession (periods of negative growth), where investment decreased and prices fell (deflation) during the 1990s. Deflation was thought to be a key to getting Japan out of a recession but it did not. There were however, several reasons for this slump, one of which was that, “there was a sharp decline in stock and land prices” (Abel, et al., 2001).
According to Keynesians, prices were sticky which meant that they would not adjust quick enough to restore equilibrium; it would require a large amount of time (Powell, 2002).
In order to recover from recession, the Keynesians proposed that the government must use expansionary monetary and fiscal policies; they must raise expenditure and lower taxes to increase aggregate demand. At the same time, the Bank of Japan lowered nominal interest rate to 0% but this did not help the economy recover and it was blamed on the limitations of the Keynesian policies. They believed that more fiscal expansion would increase the already large budget deficit and more stimulation to the economy was prevented by a liquidity trap (a situation where the public holds whatever money is supplied) (Dornbusch et al., 2001) whereby nominal interests is close or equal to zero. Monetary policy could not help in this situation because it only helped in lowering interest rates and in this case, nominal interest rate could not go below zero as it would not be possible to lend at a negative interest rate.
Below can be seen the effect of a liquidity trap:
(Abel, 2001)
Nominal and real interest rates are equal as shown. At point A, where IS1 intersects LM1, the interest rate is at zero so there is no monetary policy stimulation. The LM curve continues to remain flat and if the quantity of money is increased or decreased, it has no effect, thus it does not shift the LM curve.
If deflation and liquidity trap continues to persist and cause the real interest rate to remain at a high point, then the economy will sink further into long-lasting deflation and recession which has negative consequences. This causes unemployment to rise and a further decrease in aggregate demand which brings prices down (Svensson, 2003). In order to move out a liquidity trap, monetary policy and fiscal policy can be used if combined properly. Fiscal expansion will shift the IS curve to the right (from IS1 to IS2) and monetary expansion will shift the LM curve to the right also, from LM1 to LM2, therefore, full employment will be restored at point B (Abel et al., 2001).
In conclusion, the Keynesians have taken the view that flexible prices are independent of the full economy and that prices adjust slowly so economy does not reach full equilibrium. However, the Classical view took the stance that prices adjust rapidly to full employment equilibrium. The general equilibrium being where the FE line intersects the LM and IS. When price is adjusted, this changes real money supply (M/P) and the LM curve to shift till it meets the point where IS curve and FE line intersect. This in fact, can be juxtaposed with the Japanese liquidity trap where they deemed to shift the economy back to full employment using a combination of policies and at the same without violating the requirements of the nominal interest not going below zero.
References
Abel, A. and Bernanke, B. (2001). Macroeconomics. 4th ed. United States: Addison Wesley Longman, Inc.
Ahuja, H. (2000). Macroeconomics. Theory and Policy. Available from: [Accessed 29TH November]
Backus, D and Roubini, N. (1998). Lectures in Macroeconomics. The ISLM model. Available from: [Accessed 5th December]
Blanchard, O. (2006). Macroeconomics. 4th ed. New Jersey: Pearson Prentice Hall.
Cobham, D.(1998). Macroeconomic Analysis an Intermediate Text. 2nd ed. Essex: Pearson Education. Limited.
Dornbusch, R. et al (2001). Macroeconomics. 8th ed. New York: Mc-Graw Hill Companies Inc.
Powell, B. (2002). Explaining Japan’s Recession. Available from: [Accessed 28th December]
Svensson, L. (2003). Escaping a liquidity trap and deflation: the foolproof way and others’, Journal of Economic Perspectives. Vol. 17, No. 4, December. pp.145-166