By Brian Morgan
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Extra info for Monetarists and Keynesians: Their Contribution to Monetary Theory
Below we incorporate the Pigou effect into the model and analyse the implications of this extension in terms of the Keynesian conclusion that the economic system can settle at a position of unemployment equilibrium. The Pigou effect can be included in the model by expanding our analysis of the demand side of the goods market. e. E = C(Y)+I(r), 49 the consumption function is expanded to include the level of real wealth: d(;fO dE A change in the price level will cause the consumption and expenditure functions to shift and this will induce a shift in the IS curve; in particular ajall in prices will cause the IS curve to shift to the right.
However, in the Keynesian model there is no obvious reason why this level of output should actually be produced because, from our analysis of part (a), there is no reason why the IS and LM curves should intersect at the level of output corresponding to full employment. In fact, with the goods market in equilibrium along I SI and the money market in equilibrium along LM 1, the level of aggregate demand in the economy is such that the equilibrium level of output will be Y 1 • The level of output corresponding to the point of intersection ofthe IS and LM curves can be regarded as the actual supply of goods, and this will then determine the actuallevel of employment.
G. the Keynesian analysis takes the market interest rate as given and either (a) compares 23 C(Y)+I(r2 )=E 2 (b) C(Y) +I(r,) = E, C. ~ ai "0 a. 4 the internal rate of return of each investment project with this given interest rate, or (b) uses the market rate of in te rest to discount the expected returns from the capital asset to determine its present value or demand price. Thus the interest rate must first be ascertained from some other source bejore the investment decision-making process can begin.