The Multiplier Process as Market Exchange process A Contribution to the micro Foundation of Keynesian macroeconomics ang Gong Feb.1995 The author is very grateful to Edward Nell, Willi Semmler, Duncan Foley, David Colander John Eatwell, Paul Davidson and william Milberg for their comments and suggestions on the arly draft of this paper R Dept, of economics, Graduate Faculty, New School for Social Research, 65 Fifth Ave. New York, NY 10003 093992@newschool.edu
The Multiplier Process as Market Exchange Process A Contribution to the Micro Foundation of Keynesian Macroeconomics Gang Gong# Feb., 1995 The author is very grateful to Edward Nell, Willi Semmler, Duncan Foley, David Colander, John Eatwell, Paul Davidson and William Milberg for their comments and suggestions on the early draft of this paper. # . Dept. of economics, Graduate Faculty, New School for Social Research, 65 Fifth Ave. New York, NY 10003. 093992@newschool.edu
The Multiplier Process as Market Exchange Process A Contribution to the micro Foundation of Keynesian macroeconomics Abstract Traditional equilibrium analysis has been incorrectly founded once an"ordering issue"is concerned. To circumvent this problem, the autonomous demand, which has been missed in traditional microeconomic analysis, has to be introduced into the system as a starting point of a quence of market exchanges. Foll his direction, Keynes's multiplier analysis can also b viewed as a description of the process through which market exchanges are generated. Further, the Keynesian macroeconom ic re lation can also be proved within a micro econom ic context. JEL DO 0) he consensus in macroeconomics that prevailed until the early faltered because of no flaws, one empirical and the other theore tical theoretical flaw was that the consensus view leff a chasm betwveen microeconomic principles and macroeconomic practice that was too great to be intellectually satisfying. (Mankiw, 1990, pp. 1647) I Introduction Last twenty years have witnessed two opposite research directions. One, entitled as New Classical, is to explain macroeconomic phenomena based on an individual choice-theoretic framework of trad itional microeconomics-though the axiom of rational expectation is often adopted. The other is the attempt to reconstruct microeconomics so as to put Keynesian macro- analysis on a firmer foundation. This category is now termed New Keynesian. Is the "chasm still left? We believe (indeed many believe)"it is! " It is still not obvious what is the micro foundation of Keynesian macroeconomics
2 The Multiplier Process as Market Exchange Process A Contribution to the Micro Foundation of Keynesian Macroeconomics Abstract Traditional equilibrium analysis has been incorrectly founded once an "ordering issue" is concerned. To circumvent this problem, the autonomous demand, which has been missed in traditional microeconomic analysis, has to be introduced into the system as a starting point of a sequence of market exchanges. Following this direction, Keynes's multiplier analysis can also be viewed as a description of the process through which market exchanges are generated. Further, the Keynesian macroeconomic relation can also be proved within a micro economic context. (JEL D0, E0) "The consensus in macroeconomics that prevailed until the early 1970s faltered because of two flaws, one empirical and the other theoretical. ... The theoretical flaw was that the consensus view left a chasm between microeconomic principles and macroeconomic practice that was too great to be intellectually satisfying." (Mankiw, 1990, pp. 1647) I. Introduction Last twenty years have witnessed two opposite research directions. One, entitled as New Classical, is to explain macroeconomic phenomena based on an individual choice-theoretic framework of traditional microeconomics ⎯ though the axiom of rational expectation is often adopted. The other is the attempt to reconstruct microeconomics so as to put Keynesian macroanalysis on a firmer foundation. This category is now termed New Keynesian. Is the "chasm" still left? We believe (indeed many believe) "it is!". It is still not obvious what is the micro foundation of Keynesian macroeconomics
This paper will present my own contribution to this subject. I believe the micro foundation of Keynesian macroeconomics exists in the context of Keynes's multiplier principle. Specifically, Keynes's multiplier analysis can also be viewed as a description of the process through which market exchanges are generated. This consideration provides us a new theoretical framework The way an economy operates is completely different from the way described by trad itional equilibrium analysis. Even the concept of equilibrium has to be changed. Yet the new theoretical framework provided here turns out to be much superior in the sense that many mysteries of trad itional microeconomics automatically disappear and further, the Keynesian macroeconomic relation is exactly specified in a micro economic context The paper is organized as follows. First, I will raise an issue, which I believe has long been suppressed in economic literature. This issue is crucial, for the theoretical framework of trad itional equilibrium analy incorrectly founded once this issue is concerned. My own contribution, however, is exactly generated from my attempt to deal with this issue. I then expose how Keynes's multiplier analysis can be understood as an approach to describe the generation process of market exchanges. There are two ways of this exposition: one I call the forward exposition and the other the backward exposition. Then two possible doubts will be addressed which seem to be, in the view of many economists, unsatisfactory to the multiplier theory. A mathematical model will follow to show how Keynesian macroeconomic relation can be specified in my micro model of market exchange. Finally, the relation between this multiplier approach to other approaches on this subject will be discussed Il. Demand and Supply, which one is the first? Consider an agent who comes to an economy. He certainly wants to have two types of exchange: buying and selling. Which one should he have first? The trad itional equilibrium analysis does not offer an explicit answer. Implicitly, the system assumes that agents make their
3 This paper will present my own contribution to this subject. I believe the micro foundation of Keynesian macroeconomics exists in the context of Keynes's multiplier principle. Specifically, Keynes's multiplier analysis can also be viewed as a description of the process through which market exchanges are generated. This consideration provides us a new theoretical framework. The way an economy operates is completely different from the way described by traditional equilibrium analysis. Even the concept of equilibrium has to be changed. Yet the new theoretical framework provided here turns out to be much superior in the sense that many mysteries of traditional microeconomics automatically disappear and further, the Keynesian macroeconomic relation is exactly specified in a micro economic context. The paper is organized as follows. First, I will raise an issue, which I believe has long been suppressed in economic literature. This issue is crucial, for the theoretical framework of traditional equilibrium analysis is incorrectly founded once this issue is concerned. My own contribution, however, is exactly generated from my attempt to deal with this issue. I then expose how Keynes's multiplier analysis can be understood as an approach to describe the generation process of market exchanges. There are two ways of this exposition: one I call the forward exposition and the other the backward exposition. Then two possible doubts will be addressed, which seem to be, in the view of many economists, unsatisfactory to the multiplier theory. A mathematical model will follow to show how Keynesian macroeconomic relation can be specified in my micro model of market exchange. Finally, the relation between this multiplier approach to other approaches on this subject will be discussed. II. Demand and Supply, Which One is the First? Consider an agent who comes to an economy. He certainly wants to have two types of exchange: buying and selling. Which one should he have first? The traditional equilibrium analysis does not offer an explicit answer. Implicitly, the system assumes that agents make their
demand and supply decisions simultaneously. Then how can this simultaneity be rational ized practice? One first finds that this simultaneity is indeed rationalized in the t tonnement process Agents, in the t tonnement process, are supposed to put forward their demand and supply decisions simultaneously at quoted prices. These demand and supply decisions are not subject to actual exchanges. Actual exchanges will not take place until the equilibrium has been reached Yet outside the t tonnement, this simultaneity can hardly be rationalized First, a decision without exchange is economically meaningless. Second, agents cannot have two types of exchanges, demand and supply, to take place at the same time. Naturally there is a problem which one is the first? One should note that this issue, which one is the first? has long been suppressed in economic literature. Weintraub(1977, pp. 4)once regarded"the simultaneity"as one of the anomalies of neoclassical system, but did not provide a solution. Benassy(1982)was even entangled. In chapter 4, he distinguishes the time ordering of an agent's different decisions Through this manner, he appropriately illustrates the " spill-over effect"caused by an"initial disturbance"transmitted from market to market. Yet in chapter 7, he gives up this distinction and works again on the simultaneous nature of adjustment process. Though he believes that"in reality agents visit marke ts sequentially, "(pp 63)working on simultaneous nature, in his mind, is absolutely standard in all multi-market equilibrium model and it will simplify the exposition, as we shall not have to formalize the ordering of the markets. "(pp. 63) But this"standard"is mislead ing. In practice, agents cannot visit all markets simultaneously Second, that ordering, as we shall see later, can be formalized. Third, that ordering is crucial to economic analysis: when the ordering is appropriately formalized, the equilibrium state, at which the actual quantities are transacted, is completely different from the one achieved by the trad itional equilibrium analysis, essentially, the analysis based on simultaneity
4 demand and supply decisions simultaneously. Then how can this simultaneity be rationalized in practice? One first finds that this simultaneity is indeed rationalized in the t_tonnement process. Agents, in the t_tonnement process, are supposed to put forward their demand and supply decisions simultaneously at quoted prices. These demand and supply decisions are not subject to actual exchanges. Actual exchanges will not take place until the equilibrium has been reached. Yet outside the t_tonnement, this simultaneity can hardly be rationalized. First, a decision without exchange is economically meaningless. Second, agents cannot have two types of exchanges, demand and supply, to take place at the same time. Naturally there is a problem "which one is the first?". One should note that this issue, "which one is the first?", has long been suppressed in economic literature. Weintraub (1977, pp. 4) once regarded "the simultaneity" as one of the anomalies of neoclassical system, but did not provide a solution. Benassy (1982) was even entangled. In chapter 4, he distinguishes the time ordering of an agent's different decisions. Through this manner, he appropriately illustrates the "spill-over effect" caused by an "initial disturbance" transmitted from market to market. Yet in chapter 7, he gives up this distinction and works again on the simultaneous nature of adjustment process. Though he believes that "in reality agents visit markets sequentially,"(pp. 63) working on simultaneous nature, in his mind, is "absolutely standard in all multi-market equilibrium model and it will simplify the exposition, as we shall not have to formalize the ordering of the markets."(pp. 63) But this "standard" is misleading. In practice, agents cannot visit all markets simultaneously. Second, that ordering, as we shall see later, can be formalized. Third, that ordering is crucial to economic analysis: when the ordering is appropriately formalized, the equilibrium state, at which the actual quantities are transacted, is completely different from the one achieved by the traditional equilibrium analysis, essentially, the analysis based on simultaneity
Now let's attempt to deal with this ordering issue. Superfic ially, agents seem to demand first To supply an output, one first needs to produce it, and that requires input. This might be true in a primitive commodity economy. In such an economy, production scales are small and producers are often self-employed, though few workers other than family member may be employed. This indicates that the financial cost to produce output may be small and therefore the cost from the failure to sell the output may not be large However, in a modern mass-production economy, production is often largely scaled and financial costs to produce outputs are often high. This indicates that agents are not willing to bear the risk that their produced output cannot be sold Therefore before a producer buys input he will make sure that he can sell the associated supply, or in other words, engage in his selling activity. 1 The similarity is also applied to consumer. We cannot imag ine that a consumer would buy consumption goods without knowing whether he can or cannot or how much he can sell ou his own endowments. Though, in practice, situations may be much more complicated, the general ity is clear: agents will engage in their selling activity before their buying activ ity. Precisely in this sense, a modern capitalist economy is a demand-determined economy Now if all agents try to sell (or engage in their selling activ ity) first, where does the demand come from? If nobody tries to demand something without selling first, the system will not work For traditional equilibrium economics, this is a serious problem. It is serious because the solution to this problem cannot be derived from the traditional framework of equilibrium analysis. We indeed need a revolution in methodology Ill. Where Does the demand Come from? a Backward Exposition The selling activity may have a broad meaning. Signing a contract is certa inly a typical example. Forecasting or expecting the future sale may be an other. In traditional equilibrium analysis, an agent's expectation only depends or price. By this expectation behav ior, the ordering issue seems unimportant. Therefore, it is the expectation in such a ay that ties the two(demand and supply) together. We will argue that this expectation behavior is not justified in an uncerta inty economy. Later, we will deal with this issue in detail
5 Now let's attempt to deal with this ordering issue. Superficially, agents seem to demand first. To supply an output, one first needs to produce it, and that requires input. This might be true in a primitive commodity economy. In such an economy, production scales are small and producers are often self-employed, though few workers other than family member may be employed. This indicates that the financial cost to produce output may be small and therefore the cost from the failure to sell the output may not be large. However, in a modern mass-production economy, production is often largely scaled and financial costs to produce outputs are often high. This indicates that agents are not willing to bear the risk that their produced output cannot be sold. Therefore before a producer buys input, he will make sure that he can sell the associated supply, or in other words, engage in his selling activity.1 The similarity is also applied to consumer. We cannot imagine that a consumer would buy consumption goods without knowing whether he can or cannot or how much he can sell out his own endowments. Though, in practice, situations may be much more complicated, the generality is clear: agents will engage in their selling activity before their buying activity. Precisely in this sense, a modern capitalist economy is a demand-determined economy. Now if all agents try to sell (or engage in their selling activity) first, where does the demand come from? If nobody tries to demand something without selling first, the system will not work. For traditional equilibrium economics, this is a serious problem. It is serious because the solution to this problem cannot be derived from the traditional framework of equilibrium analysis. We indeed need a revolution in methodology. III. Where Does the Demand Come from? a Backward Exposition 1 . The selling activity may have a broad meaning. Signing a contract is certainly a typical example. Forecasting or expecting the future sale may be an other. In traditional equilibrium analysis, an agent's expectation only depends on price. By this expectation behavior, the ordering issue seems unimportant. Therefore, it is the expectation in such a way that ties the two (demand and supply) together. We will argue that this expectation behavior is not justified in an uncertainty economy. Later, we will deal with this issue in detail