Student Number: 231174

Student Name and Surname: Tayyeba Shoaib

Course Title: Macroeconomic Analysis A14/15
Course Code: 153400123-A14/15
Convenor/Tutor Name: Rory MacQueen
Word Count: 2499

What is the neoclassical synthesis? How did it give rise to theoretical schizophrenia in postwar mainstream macroeconomics and how was this inconsistency resolved in subsequent
contributions to mainstream macroeconomics?
The neoclassical synthesis was the dominant paradigm in the decades following the WWII and
synthesizes ideas from both Keynes and the Classics. The term was first coined by Samuelson and he
argues that, 'In recent years, 90 per cent of American Economists have stopped being Keynesian
economists or anti-Keynesian economists. Instead they have worked toward a synthesis of whatever
is valuable in older economics and in modern theories of income determination. The result might be
called neo-classical economics and is accepted in its broad outlines by all but about 5 per cent of
extreme left wing and right wing writers' (Samuelson 1955: 212). The synthesis used the classical
model for microeconomic issues and long-term growth, whereas Orthodox Keynesianism helped in
the analysis of short-run aggregate phenomenon. This led to schizophrenia on a theoretical level, as
the Keynesian propositions of market failure and involuntary unemployment at the macro level didn't
rest easily alongside the Walrasian theory used at the micro level, where markets (including the labour
market) always clear. This was resolved in two ways. The first was the new classical school which
tried to adopt the macro theory to the micro theory and the second was the new Keynesian school
which tried to change the micro foundations to fit better with the macro.
The IS-LM model of aggregate demand was the leading orthodox Keynesian interpretation of
Keynes's General Theory and formed the backbone of theorizing in the synthesis. It was first
introduced in a classic article by the Nobel Prize-winning economist John R. Hicks, "Mr. Keynes and
the Classics: A suggested interpretation," (Econometrica 5 (19370): 147-159). The goal of the model
is to show what determines national income or what causes aggregate demand curve to shift when the
prices are fixed. In the orthodox Keynesianism, aggregate output and employment is determined by
aggregate demand.
The IS (Investments and Savings) part of the model represents the goods and services market.
Aggregate demand in a closed economy consists of government expenditure, consumption and
income. In the model, government expenditure is taken as exogenous, consumption expenditure
depends on the level of income and investment is inversely related to the rate of interest, a variable
determined within the model. A higher interest rate lowers planned investment and this in turn lowers
national income. The downward sloping IS curve summarizes the negative relationship between the
interest rate and income associate with equilibrium in the goods market. Equilibrium occurs in a
closed market with no government sector when investment (I) equals savings (S), or the aggregate
demand for goods and aggregate supply of goods are equal.

The LM (Liquidity and Money) curve represents equilibrium in the money market. It plots the
relationship between the interest rate and the level of income that arises in the market for money
balances. The interest rate adjusts to balance the supply and demand for the economy's most liquid
asset _ money. The supply of real money balances is assumed to be exogenously determined. The
demand for real money balances depends on three motives: the transactions, the precautionary and the
speculative motive. The demand for transactions and precautionary balances is assumed to vary
positively with income. The demand for speculative balances depends on the level of current interest
rate relative to normal interest rate and varies inversely with the interest rate. The higher the current
level of interest rate (relative to the normal interest rate), the greater the number of people who expect
interest rate to fall in the future (and hence, bond prices to rise); the lower will be the speculative
demand for money, and vice versa. At the equilibrium interest rate, the quantity of real money
balances demanded equals the quantity supplied.
To determine the relationship between interest rate and income we ask the following question: how
does a change in economy's level of income (Y) affect the market for real money balances? When
income is high, expenditure is high, so people engage in more transactions that require the use of
money. Thus, greater income implies greater money demand. This increase in income shifts the
money demand curve to the right. With the supply of money unchanged, the interest rate must rise
from r1 to r2 to equilibrate the money market. Therefore, a higher income leads to a higher interest
rate.
Equilibrium in both the goods market and the money market is simultaneously attained where the IS
curve and the LM curve intersect, as seen is figure (a). The intersection of the curves gives us a
unique value of the interest rate and income which is consistent with equilibrium in both markets.
(a)

LM0

r
re

IS
Ye

The model integrates real and monetary factors in determining aggregate demand and therefore the
level of output and employment. Unlike the classical model, where in a competitive economy there
would be an automatic tendency for full employment to be established, there is no reason to assume
that in the IS-LM model the equilibrium level of income generated will be necessary for full
employment.

(b)

LM0
LM1

r
re

E0
E1
IS
Ye YF

As can be seen in figure (b), while both the goods and the money market are in equilibrium, the
income generated is less than the full-employment level of income (Y F). In this case, the real wage
rate would be above that of the market clearing wage. The excess supply of labour has no effect on the
money wage, due to the Keynesian assumption of downward money wage rigidity and it is possible
for the economy to be at equilibrium with persistent unemployment.
We now combine the IS-LM model with the classical assumption of flexible prices and money wages.
Suppose the economy is initially at equilibrium (E0), income level of Y0 is below full employment
income level (YF). The real wage rate is above the market clearing wage rate. As long as prices and
money wages are perfectly flexible, the economy will self-equilibrate at full employment. The excess
supply of labour results in a fall in money wages (W), which reduces firms costs and causes a fall in
prices (P). The fall in prices increases the real value of money supply, causing the LM curve to shift
downwards to the right. Excess real balances are channelled into the bond market where bond prices
are bid up and the rate of interest falls. The resultant fall in the rate of interest in turn stimulates
investment expenditure, increasing the level of aggregate demand and therefore output and
employment. The indirect effect of falling money wages and prices which stimulates spending via
the interest rate is referred to as the Keynes effect. The increase in aggregate demand moderates the
rate of fall in prices so that as money wages fall at a faster rate than prices (an unbalanced deflation),
the real wage rate falls towards its full employment market clearing level. Money wages and prices
will continue to be down and the LM curve will continue to shift downwards to the right until full
employment is restored and excess supply of labour is eliminated.
Within this general framework there are, however, two limiting cases where despite perfect money
wage and price flexibility, the economy will fail to self-equilibrate at full employment. The two
special cases are the liquidity trap and interest-inelastic investment expenditure.
In the liquidity trap case, the economy is initially at point E0, as seen in figure (c).

(c)

r
r*r1

The income level of Y0 is below the full employment income level YF and the real wage rate is above
the market clearing wage rate. The excess supply of labour results in a fall in money wages, which
reduces firms costs and causes a fall in prices. The fall in prices increases the real value of the money
supply, which shifts the LM curve outwards, from LM0 to LM1. However, if interest rates are already
near to zero (r*), the demand for money becomes perfectly elastic (the flat part of the LM curve).
Nominal interest rates cannot fall below zero: rather than making a loan at a negative interest rate, a
person would just hold cash. As the rate of interest doesn't fall, investment doesn't increase, which
would be required to stimulate the aggregate demand and restore full employment. With no increase
in aggregate demand to moderate the rate of fall in prices, prices fall in proportion to the fall in money
wages (a balanced deflation) and real wages remain above their market clearing level. Aggregate
demand is insufficient to achieve full employment and the economy remains at less than full
employment equilibrium with persistent involuntary unemployment. In the case of liquidity trap,
fiscal policy becomes all powerful as a means of increasing aggregate demand and restoring full
employment, while monetary policy becomes impotent.
In the interest inelastic investment case, the economy will also fail to self-equilibrate at full
employment. As before we assume that the economy is initially at point E 0, at the income level Y0
which is below full employment (YF).
(d)

YF

IS0

LM0
LM1
E0
E1

E2

Y0 Y1 YF

As the level of employment is below the full employment level, the real wages is above the market
clearing wage rate. The excess supply of labour results in a fall in money wages and prices. Although
the increase in real money balances (which shifts the LM curve from LM 0 to LM1) through the
Keynes effect results in a reduction of interest rate, the fall in the rate of interest is insufficient to
restore full employment. With investment expenditure being so interest-inelastic, full employment
equilibrium cannot be restored through the Keynes effect. The economy would come to rest at E 1, a
point of underemployment equilibrium (Y1) with persistent involuntary unemployment.
This shows that Keynes General theory of unemployment equilibrium came to rely on rigid money
wages, the liquidity trap or interest inelastic investment. However, once the Pigou effect is taken into
account, unemployment equilibrium relies solely on rigid money wages. The Pigou effect is another
channel through which falling prices expand aggregate demand and hence income. Arthur Pigou, a
prominent classical economist in the 1930s, pointed out that real money balances are part of

households' wealth. As prices fall and real money balances rise, consumers should feel wealthier and
spend more. This increase in consumer spending should cause an expansionary shift in the IS curve,
also leading to higher income.
According to Johnson (1964; cited in Snowdon 2005:121), 'the Pigou effect finally disposes of the
Keynesian contention that underemployment equilibrium doesn't depend on the assumption of wage
rigidity. It does.' 'Volatile expectations about an uncertain future have a key role to play in Keynes's
explanation of the business cycle' (Hillier 1991:1), however, The IS-LM model doesn't take into
account the importance of expectations. Hence, Keynes' general proposition of unemployment
equilibrium became a special case of the Classical model.
The synthesis remained dominant until the early 1970s, when the dramatic changes in the economy
threw it into disarray. In particular, the great inflation of the early 1970s led to a closer investigation
of the analytical foundations of the synthesis and exposed its theoretical schizophrenia.
Neoclassical synthesis gave rise to 'theoretical schizophrenia' as it wasn't grounded in methodological
individualism, where the macro is an aggregate of the results established at micro level. At the micro
level students were taught the Walrasian general theory which was based on perfect competition,
perfect information, complete set of markets, constant return to scale and no transaction costs. In this
general equilibrium model, the actions of rational optimizing individuals should ensure that all
markets, including the labour market are cleared by flexible prices. However, at the macro level
students studied the Keynesian proposition of market failure and involuntary unemployment.
'Keynesian macroeconomics and orthodox neoclassical microeconomics integrated about as well as
oil and water' (Snowdon 2005: 21). 'The neoclassical synthesis floundered on what seems, in
retrospect an obvious question: in an environment that is so relentlessly competitive, how can one
glaring departure from Walrasian behaviour persist?' (Romer, 1993: 3). However, Keynes himself was
against methodological individualism as he argued 'that important mistakes have been made through
extending to the system as a whole conclusions which have been correctly arrived at in respect of a
part of it taken in isolation (Keynes, 1936: 32). He had no problem with the analysing micro
phenomenon with the help of the classical model, but emphasised the need for demand management
policies to bring about full employment at the macro level and felt that once this was accomplished
'the classical theory comes into its own again from this point onwards' (Keynes, 1936: p 378).
This problem was solved in two ways. The first was the new classical approach which tried to adapt
the macro theory to the orthodox micro theory. The second was the new Keynesian approach which
tried to find more appropriate micro foundations to a non-market clearing macro analysis. Both
schools of thought used methodological individualism and believed that macroeconomic models are
best constructed within a general equilibrium framework.

The new classical school used the Walrasian general equilibrium model at the micro level and
believed that markets continuously clear if governments are prevented from conducting discretionary
policies. It posited that all points on the business cycle are equilibrium points and hence all
unemployment is voluntary. The inconsistency with optimisation implied by the adaptive expectations
hypothesis was resolved by introducing rational expectations hypothesis according to which people
optimally use all available information when forecasting the future. Random errors on average
become zero and expectations are correct. The only way for the output to vary from its natural rate is
as a result of a surprise supply function: a surprise change in the monetary stance of the authorities.
This was challenged by the new Keynesian school amid the high unemployment in Europe during the
1980s and they tried to 'determine whether a correct description of the microeconomy would give rise
to the phenomenon that they believed characterized the macroeconomy' (Romer 1993: 3), i.e.
involuntary unemployment and non-market clearance. They build their argument on non-Walrasian
micro foundations. The macro was an aggregation of imperfect competition, asymmetric information,
increasing returns to scale, transaction costs and missing markets. There is no unified new Keynesian
model; rather there are many explanations of wage and price rigidities and their macroeconomic
counterparts.
Despite Keynes's insistence that the existence of wage and price flexibility in a economic system
doesn't guarantee full employment, orthodox Keynesianism reduces Keynes's General theory to a
special case of the classical model, where unemployment equilibrium depends on wage and price
rigidity. The fact that micro foundations were based on Walrasian general theory markets always clear,
whereas at the micro level there was involuntary unemployment led to theoretic schizophrenia. This
was solved by theories based on methodological individualism which either tried to change the macro
theory to fit the orthodox micro theory (markets always clear) or tried to change the micro to fit nonclearing macro economy (imperfect markets).

Bibliography

Samuelson, P. Economics, 3rd edition. New York: McGraw-Hill, 1955.

Snowdon, B, and H.R. Vane, Modern Macroeconomics: Its Origins, Development and Current

State, Cheltenham: Edward Elgar, 2005.

Hillier, B, The Macroeconomic Debate. Models of the Closed and Open Economy, Oxford

and Cambridge: Basil Blackwell, 1991.

Romer, D. (1993), The New Keynesian Synthesis, Journal of Economic Perspectives, No.1,

Winter 1993.
Keynes, J. M. (1936), The General Theory of Employment, Interest and Money, London:
Macmillan.