What is the neoclassical synthesis?

How did it give rise to theoretical

schizophrenia in post-war 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 Second World War and synthesizes ideas from both Keynes and the Classics.
The term was first coined by Samuelson in the third edition of his textbook
Economics published in 1955, in which 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. 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. It was committed to
methodological individualism, i.e. the macro economy emerges out of the
aggregating the results that emerge in micro. This led to schizophrenia on a
theoretical level, as the Keynesian propositions of market failure and involuntary
unemployment at the macro level did not rest easily alongside the Walrasian
theory of general competitive equilibrium, where the actions of rational
optimizing individuals ensure that all markets, including the labour market are
cleared by flexible prices. The issue was resolved in two ways. The first tried to
adopt the macro theory to orthodox neoclassical micro theory and the second
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 neoclassical 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. To understand this relationship, we
begin by looking at a theory of interest rate called the theory of liquidity
preference. The theory of liquidity preference describes Keynes' views about how
interest rate is determined in the short run. His explanation is called the liquidity
preference because he posits that 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.
According to the theory of liquidity preference, the supply and demand for real
money balances determine what interest rate prevails in the economy. That is
the interest rate adjusts to equilibrate the money market. 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. The intersection of the
curves gives us a unique value of interest rate and income which is consistent
with equilibrium in both markets.
LM
(a)
r
re
IS
Y
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. Within the model, the unemployment equilibrium can be attributed
What effect does combining the IS-LM model with the Classical assumption of
flexible prices and money wages has on the theoretical possibility of
underemployment equilibrium?
Initially at equilibrium, income level of Y0 below full employment income level.
The level of employment is below its full employment level with real wages
above their market clearing. As long as prices and money wages are perfectly
flexible, the economy will, however, self-equilibrate at full employment. At (W/P) 0
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 is bid down. 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. It is important to stress that it
is the increase in aggregate demand, via the Keynes effect, which ensures that
the economy returns to full employment.
Within this general framework there are, however, two limiting or special cases
where despite perfect money wage and price flexibility, the economy will fail to
self-equilibrate at full employment.
The two special cases are (i) the liquidity trap (ii) interest-inelastic investment
expenditure.
In the liquidity trap case, the economy is initially at point E 0, the intersection of IS
and LM curves.
Although both the goods and the money market are in equilibrium, the income
level of Y0 is below the full employment income level YF. The level of employment
is below its full employment level with real wages (W/P)0 above their marketclearing level (W/P)1. At (W/P)0 the excess supply of labour results in a fall in
money wages (W), which reduces firms costs and causes a fall in prices.
Although the fall in prices increases the real value of the money supply (which
shifts the LM curve outwards, from LM 0 to LM1, the increased real balances are
entirely absorbed into idle or speculative balances. In the liquidity trap where the

demand for money is perfectly elastic with respect to the rate of interest at r*,
the excess balances will not be channelled into the bond market and this
prevents a reduction in the rate of interest to r 1 which would be required to
stimulate aggregate demand and restore full employment. With no increase in
aggregate demand to moderate the rate of fall in prices, prices fall
proportionately to the fall in money wages (a balanced deflation) and real wages
remain above their market clearing level. Aggregate demand 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, monetary policy become impotent and fiscal policy becomes all-powerful,
as a means of increasing aggregate demand and therefore the level of output
and employment.
In the interest inelastic investment case, the economy will also fail to selfequilibrate at full employment. As before we assume that the economy is initially
at point E0, where the IS and the LM curves interact, at the income level Y 0 which
is below full employment (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 could only
be restored through the Keynes effect with a negative interest rate. In theory the
economy would come to rest at E1, a point of underemployment equilibrium (Y1)
with persistent involuntary unemployment.
The effect of combing the comparative-static IS-LM model with the classical
assumption of flexible prices and money wages is to imply that Keynes failed to
provide a robust 'general theory' of underemployment equilibrium and that the
possibility of underemployment equilibrium rests on two highly limiting/special
cases.
Owes much to the work of Modigliani
Pigou effect (Pigou (1943), Patinkin (1956)): the wealth effect on consumption
or the real-balance effect on consumption. Strictly speaking, the Pigou effect
denotes the effect of falling prices on expenditure via the real balance effect,
since Pigous arguments depend on falling prices and wealth effects.
The Pigou effect
Pigou argued that providing money wages and prices were flexible, the IS-LM
model would not on underemployment equilibrium
within mainstream economics the neoclassical synthesis constituted the
Keynesian tradition for the initial decades of the post-war period. Its commitment
to methodological individualism, and the particular nature of its micro
foundations (Walrasian), however, had infused macroeconomics with a certain

inconsistency between its micro and macro part. At the micro level economic
agents were optimising (profit or utility) in a world of perfect competition, perfect
information, complete markets, . (orthodox micro economics); at the macro
level however unemployment persisted as the money way was rigid (neoclassical synthesis). Yet in the context of a description of the micro environment
as Walrasian (pc, perfect information, no transaction costs, ), the question then
obviously arose as to why at the macro level such a departure from Walrasian
behaviour would persist. If the macro economy is a mere aggregation of
outcomes of optimisation of individual economic agents (methodological
individualism), why would, in a competitive environment with perfect
information, total set of markets, etc., incentives to economic agents to adjust
their prices in response to an imbalance between supply and demand not arise?
The issue remained unresolved (and unnoticed) until the end of the golden age
(post war boom). Dramatic changes in the performance of the economy threw
Keynesian economics into disarray, and closer investigation of the analytical
foundations of the Keynesian consensus exposed its theoretical schizophrenia

In the neoclassical synthesis, the economy is inherently unstable and is subject

to erratic shocks. These shocks are mainly due to changes in the marginal
efficiency of capital following a change in the state of business confidence, or
what Keynes referred to as a change in investors 'animal spirits'. The IS-LM
model.
The focus on the tractable, and quite elegant, comparative static IS-LM model
diverted attention away from Keynes's dynamic arguments and led to an
interpretation of the General Theory as simply a special case of the Classical
model.