The Neoclassical Macromodel

"The theories of individual behavior provide a complete set of inter-relationships within the
economy, e.g. they give us the demand-and-supply relationships of every commodity in the
system...A mathematical representation of [Walras's system] would probably involve
several million equations in several million unknowns, an incomprehensible maze. To
make any useful economic judgements, one must simplify this system into a manageable
number of relationships among aggregates of the fundamental prices and quantities."
(Lawrence Klein, The Keynesian Revolution, 1947: p. 57)
"It is self-contradictory to discuss a process which admittedly could not take place without
money, and at the same time to assume that money is absent or has no effect."
(Friedrich A. von Hayek, Pure Theory of Capital, 1941: p.31)
"With perfectly free competition among work-people and labour perfectly mobile, the
nature of the relationship [between wages and labor demand] will be very simple. There
will always be at work a strong tendency for wage rates to be so related to demand that
everybody is employed. Hence, in stable conditions every one will actually be employed.
The implication is that such unemployment as exists at any time is due wholly to the fact
that changes in demand conditions are continually taking place and that frictional
resistances prevent the appropriate wage adjustment from being made instantaneously."
(Arthur C. Pigou, Theory of Unemployment, 1933: p.252)
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Contents
(A) The Fisherian Vision
(B) The Macromodel
(C) The Microfoundations
(D) Some Difficulties
(A) The Fisherian Vision
The "Fisherian" approach is so named because of the fundamental contributions of Irving
Fisher (1907, 1911, 1930), but it might as well be called the "Lausanne" system as it
exhibits the same properties and structure of the general equilibrium systems of Lon

Walras and Vilfredo Pareto. We must not forget that, as Morishima (1977) reminds us, that
perhaps uniquely among all pre-1920 economists, Walras (1874) did attempt to incorporate
money, capital and growth into his story in a "wholly Neoclassical" manner. But Walras's
efforts were tentative and subsequently ignored. What Fisher did, particularly in his 1930
work, was to return to Walras's task in the context of a simplified general equilibrium
model.
Fisher treated "macro" as merely "aggregated micro", a jazzed-up "G.E." system (we must
recall that when Frisch (1933) invented the term "macroeconomics", he was including the
Walrasian economy-wide system of markets into his definition). Consequently, the
Fisherian macromodel is a "real" system, i.e. money remains neutral, Say's Law is held to
be true, thus there is no possibility of aggregate demand exceeding or falling below
aggregate supply.
Yet what was the purpose of building a "macromodel" if all it turns out to be is the old
Walrasian G.E. model with all the trappings of being "static" and "equilibrium"-based?
How is this supposed to explain movements in output as a whole? Well, it will explain
these in a very simple way: namely, it asserts that macrofluctuations must arise from
elswhere.
This may seem like a anti-climatic conclusion, but it is not ducking the issue completely.
What the Fisherian approach asserts is that macrofluctuations will never arise from within a
perfectly working system. If we see movements in macro variables like aggregate output,
the price level, or interest rates, then one of the following must be the cause:
(1) there is a real change, i.e. people's preferences, technology and/or endowments have
changed, and all that we are observing is merely a change in equilibrium. The fluctuation is
not a "crisis" at all, but actually an efficient response.
(2) money has changed and price levels fluctuate, but the "real" economy has not changed
at all. The fluctuation is only nominal or "illusory". This is not a "crisis", merely an
inconvenience.
(3) there has been a monetary change as in (2) but, because of sluggish or uncoordinated
price adjustments, it has thrown all real prices into confusion and led to wrong signals and
misallocations. This is a "crisis", but it is only temporary.
(4) there has been a real change as in (1), but for some reason or another (e.g. labor unions,
etc.), there are institutional rigidities that prevent real prices from adjusting to the new
equilibrium. This is a serious "crisis" that may last for a long time unless (or until) the
institutional rigidities are removed.
The Fisherian macromodel will be discussed in more detail in this next section, but we
already see its essential contours. There is a "real" economy, governed by "real supply and
demand" which will determine the aggregate output level, the aggregate (full) employment
level and the real (i.e. relative) prices of goods and factors. This is an equilibrium system
which, bar any "real" changes in the primitives, remains comfortably stable. Changes in

money will not change anything but the absolute price level. Thus, the actual cause of
fluctuations in output and employment must arise because of factors which are effectively
outside of this system. They arise from money illusions, badly-placed expectations,
miscoordination and institutional rigidities, etc. that come into play during what would
otherwise be a smooth and natural adjustment process, whether this adjustment is in
response to nominal changes (as in (3)) or real changes (as in (4)). The economy will not
"generate" these fluctuations by itself.
Naturally, the Fisherian model is not wholly or only Irving Fisher's. The contributions of
Gustav Cassel (1918), Alfred Marshall (1923), Arthur Pigou (1927, 1933), Ralph G.
Hawtrey (1913, 1926), Dennis Robertson (1926) and John Maynard Keynes (1923, 1930),
are all really in this Fisherian tradition. They all looked for their explanations for
fluctuations in real output in exogenous frictions, rigidities and imperfections in real
variables or else confined their explanations of the cycle to fluctuations in the absolute
price level.
What we (and almost everybody else) calls the Neoclassical macromodel refers inevitably
to the Fisherian version of it. It may not seem like a very interesting story, but by staying
close to general equilibrium theory, its Neoclassical credentials cannot be doubted. The
question is whether this is too high a price to pay. Cannot one create a thoroughly
Neoclassical macromodel which says a little bit more about fluctuations than that? One
famous but ill-fated attempt to do so was that of Friedrich A. von Hayek (1929, 1931),
which we treat elsewhere.
(B) The Macromodel
The (Fisherian) Neoclassical model of the macroeconomy has what may be regarded as a
"supply-determined" equilibrium. Indeed, the first step of Neoclassical theory is to
recognize that there are scarce factors that need to be efficiently allocated to satisfy as
many wants as possible. Thus, the crux of Neoclassical theory is to take a given endowment
of factors and, by a process of successive substitution, determine the most efficient
allocation possible. The operator is the price system - or, in a single market, using pricesensitive demand and supply functions to determine the equilibrium price that will clear it.
To understand the major relationships, let us the following "catena" or quick summary of
the essence of the Neoclassical macromodel:
(1) Factor supplies and factor demands determine factor returns and factor employment.
(2) Factor employment and technological possibilities determine aggregate supply.
(3) Aggregate supply and aggregate demand determine the equilibrium rate of interest.
(4) Money demand and money supply determine the price level.

The essential features of the Neoclassical macromodel are shown diagramatically in Figure
1, with causality running from Quadrant I (upper right) to Quadrant III (bottom left).

Figure 1 - The Neoclassical Macromodel

In order to work through this diagram, let us then begin with the first line of the catena, the
factor markets. Let w/p be the real wage (where w is nominal wage and p is the price level).
Let N be labor. Then we are allowed to write out the labor demand function as:
Nd = Nd(w/p)
where dNd/d(w/p) < 0 so that labor demand is a negative function of the real wage. This
relationship arises from the substitution by profit-maximizing firms between labor and
other factors. At high real wages, firms will opt for less labor-intensive techniques and at
low wages, they will opt for more labor-intensive techniques. So, if labor is relatively more
expensive, the demand for labor declines and thus, the labor demand curve is downward
sloping, as shown in Quadrant I of Figure 1.
Let us now turn to labor supply. Here we have:
Ns = Ns(w/p)
where dNd/d(w/p) > 0 so that labor supply is a positive function of the real wage. The
upward-sloping labor supply function in Quadrant I of Figure 1 also arises from
substitution - this time between work and leisure on the part of the household. The greater
the real wage, the more labor is supplied.

The equilibrium in the labor market and is given by:

Nd(w/p) = Ns(w/p)
which gives us the equilibrium real wage (w/p)* and the equilibrium level of employment
(N*), a shown in Quadrant I of Figure 1. Given these conditions, then by total
differentiation we know that:
dw/w = dp/p
i.e. nominal wages (w) are fully flexible and will accompany changes in the price level (p)
by the same proportion in order to maintain (w/p)* and, by extension, N*. This flexibility
need not be necessarily instantaneous - adjustment can take time - but it is certainly the
"long-run" tendency. In sum, in the long run, employment does not change with a different
price level since nominal wages will change proportionately.
Thus, we have obtained the first line of the catena and the first quadrant of Figure 1. We
have also, by extension, obtained the second one as well. Proposing a short-run production
function Y = (N), then given N* from the labor-market clearing we just derived, we
obtain, immediately, the level of aggregate supply, Y*. This is shown in Quadrant II of
Figure 1.
Now, turning to the goods market in Quadrant III of Figure 1, we notice that the aggregate
supply curve is horizontal (or vertical, in normal perspective). In other words, aggregate
supply, Y*, is derived entirely from factor-market clearing - thus the output of goods in an
economy is wholly "supply-determined". The greater the level of employment, N*, the
greater the level of output, Y*. Thus, the supply of goods enters the goods market already
determined and is invariant to anything that happens within the goods market alone.
Now we turn to the third line in the catena. The given output Y* will be factor income
which is, in turn, consumed, saved or taxed away, thus:
Y=C+S+T
Aggregate demand, Yd, however, is composed of consumption, investment and government
expenditures, thus:
Yd = C + I + G
Thus, for there to be an equilibrium in the goods market, for aggregate demand to be equal
to aggregate supply of goods (Yd = Y), then it must be that C + I + G = C + S + T or,
cancelling out C and flipping G over:
I = S + (T - G)

Thus the condition for equilibrium in the goods market is that investment be equal to
savings -- where savings here is defined as private sector saving, S , and public sector
saving, (the excess of government revenue over expenditures, or T-G). This is equivalent to
the loanable funds theory which says that the supply of loanable funds (public plus private
savings) be equal to the demand for loanable funds (investment) in equilibrium.
What brings this equilibrium about? Movements in the rate of interest. The interest rate
adjustes to bring Yd in equality with Y (or, equivalently, I into equality with S). This is in
stark contrast to the Keynesian multiplier where it is output itself that adjusts to equate
investment and savings. Thus, we shall argue that interest in the Neoclassical model does
not affect aggregate supply, but rather affects only aggregate demand.
Given that the rate of interest affects aggregate demand, how does it do so? The most
straightforward channel is through investment. This is essentially the flow relationship
proposed by Irving Fisher (1930) in his "second approximation". The reasoning for the
negative relationship between investment and interest rate is given in more detail
elsewhere. Thus, investment demand is negatively related to the rate of interest, I = I(r)
where I(.) < 0.
However, there is a second relationship between r and aggregate demand - namely through
consumption and savings. Via Fisher's (1930) "first approximation", we obtain the result
that C = C(Y, r), i.e. consumption is a function of income and interest and that CY > 0 and
Cr < 0, i.e. increases in income raise consumption whereas increases in interest reduce it. In
other words, as interest rate rises, the desirability of saving is higher. Thus, in our general
consumption function, C = C(Y, r), we have it that Cr < 0.
Thus, we have the main relationships needed for aggregate demand, i.e.
Yd = C(Y, r) + I(r) + G
As noted, Cr < 0 and Ir < 0, thus the aggregate demand function is downward sloping with
respect to interest. Aggregate supply is invariant with interest. Thus, the third line of the
catena is fulfilled by recognizing that Yd = Y will be equated by movements in the rate of
interest. All this is shown in Quadrant III of Figure 1.
But everybody knows that the interest rate is determined in the market financial assets.
How is this related? The adjustment mechanism of the goods market should be expanded
upon as it relates to Fisher's (1930) theory of loanable funds. This can be verified by
considering the firm's investment decision and the household's consumption-savings
decision simultaneously. "Loanable funds" are demanded by firms who need it for
investment and loanable funds are supplied by households who need some place to put their
savings. If a firm demands loanable funds, it will issue (i.e. supply) bonds; if a household
supplies loanable funds, it will seek to buy (i.e. demand) bonds. Thus, I = Bs and S = Bd
(note: Bd and Bs must be flow terms, thus they are not the demand and supply of the stock
of bonds, but rather the demand and supply of new bonds).

The relationship between the three markets is depicted intuitively in Figure 2. If interest
clears the loanable funds (e.g. is at r* in Figure 2) market, Bd = Bs, then obviously it is
equivalent to saying that I = S and therefore Yd = Y. If interest is too low (e.g. at r1 in
Figure 2), so that there is excess demand for goods Yd > Ys or, equivalently, excess
investment demand, I > S, which implies in turn that there must be excess bond supply, Bs
> Bd. The reverse applies if interest rates are too high (e.g. at r2).

Figure 2 - Interest Rates

Applying standard market-clearing arguments for the loanable funds market, we can say
that if r is too high (e.g. at r2), then the interest will have to fall to equilibriate the loanable
funds market (Bd=Bs) and so, by extension, the goods market (Yd=Ys). Step-by-step, the
fall in interest leads to an increase in investment demand and an decrease in savings via the
effect on intertemporal allocation of consumption. These effects are equivalent, in
Neoclassical theory, to a reduction in the demand for loanable funds and an increase in their
supply.
Note that in this simple model, the change in the rate of interest, r does not affect aggregate
supply. We could posit that it does - by some argument that labor supply or labor demand
varied with r. But that would complicate our story somewhat -- and our original equations
for Nd and Ns do not have r as arguments. Thus, in this simplified model, aggregate demand
does all the adjusting. Aggregate supply is "predetermined" in the factor markets.
Finally, we should note that we have assumed that household savings are equivalent to the
demand for loanable funds without considering that they may desire to place their savings
in other assets (such as money or goods themselves). As Keynes (1936) demonstrated,
when these other assets are taken into account, there will some quite important
modifications to our conclusions.

But where is money anyway? The Neoclassicals appended this on top of their existing
construction. In the Cambridge cash-balance theory developed by Marshall (1923), Pigou
(1917) and Keynes (1923), the interest rate and output will themselves feed into the money
market by influencing the demand for real money (Md). i.e.
Md = L(r, Y)
where Lr < 0 and LY > 0 (the why of the first relationship is hard to reconcile with the
loanable funds theory given earlier, but the Neoclassicals thought it logical, although
Keynes, who developed this theory, saw it as the first approximation to his liquidity
preference theory). If real money demand, Md, is determined by r and Y and r and Y are
determined in the real markets for goods and factors, then if these are unchanged, then Ld
will be unchanged.
We are also given and (exogenous) real supply of money:
Ms = M/p
where M is the nominal money stock. For there to be money market equilibrium, Md = Ms,
or:
L(r, Y) = M/p
However, as money demand is fixed externally and M is controlled by the central bank (an
assumption), then all that remains to adjust this market into equilibrium is the general price
level, p.
The money market is illustrated in Figure 3, which is drawn in nominal terms, thus we have
nominal money demand curve pMd = pL(r, Y) and nominal money supply schedule pMs =
M where nominal money stock M* is given exogenously and thus only p* is left to be
determined by equilibrium condition pL(r, Y) = M.

Figure 3 - The Money Market

Having determined the price level, p*, in the money market, do we need to go back and
change anything we had before? No. The determination of money market has no impact on
the determination of the real variables w/p, N, Y, r and B.
Now, we could speculate that a change in the price level might affect real wages (w/p) - the
only point p enters anywhere else in the system - but in fact, as we have seen, nominal
wages (w) are assumed to be entirely flexible and so will adjust proportionately in the
factor markets to maintain the market-clearing real wage (w/p)*, i.e. dw/w = dp/p. This
implies that money is neutral, i.e. changes in the supply of money do not affect real
variables.
Notice that the real money demand function Md = L(r, Y) can be represented via two
famous alternative ways. For instance, in the Cambridge cash-balance approach, we can
posit the shape Md = kY (where the Cambridge constant, k, varies negatively with r).
Alternatively, we can use Irving Fisher's (1911) form and represent money demand
function as Md = (1/V)Y (where velocity, V, varies positively with r). Thus, money market
equilibrium condition in Figure 3, that Ms = Md or M/p = L(r, Y) can be rewritten as:
M/p = kY
which is the "Cambridge equation" or:
M/p = (1/V)Y
which is the Fisherian "equation of exchange". The money market equibrium depicted in
Figure 3 is compatible with either of these.
Because of the manner in which w/p is completely flexible and given the other relationships
we have outlined here, there are three primary features of the Neoclassical model which are
preserved here. Firstly, there is a strict dichotomy between the money market and the real
market - what happens in the former does not affect the latter. Secondly, and by extension,
money remains neutral, i.e. a rise in the supply of nominal money (M) will not affect any
other variables other than the price level. A third, related characteristic is that we obtain the
conclusion of the Quantity Theory of Money strictly: a change in the money supply will
change price level proportionately but not anything else.
The summary of the main points of this simplified version of the Neoclassical model are
then the following.
(1) factor market equilibrium determine the real wage (w/p)* and the level of employment
N*. There is no involuntary unemployment as Nd = Ns = N*.

(2) Output level Y* is supply-determined, i.e. determined, via the production function Y =
(N), from the level of employment determined in the factor markets, N*.
(3) Goods markets are brought into equilibrium by interest rates, i.e. at the equilibrium
interest rate r*, aggregate demand equals aggregate supply and investment equal saving
and demand for loanable funds equals the supply of loanable funds.
(4) The Quantity Theory of Money holds, i.e. money is neutral, so that changes in the
supply of money only affect the absolute price level and do not affect any real variables.
(C) The Microfoundations
We ought to emphasize a fifth feature of this model, namely that the foundations of the
model are firmly set in Neoclassical micro-theory: (1) output, factor employment and
investment are derived from firms' profit-maximizing decision (2) labor supply,
consumption and savings are derived from household utility-maximization and (3) marketclearing conditions are imposed on all markets.
Let us assume there are H households and F firms. We will focus on the representative
household (the "hth" household) and the representative firm (the "fth" firm), before
aggregating.
Looking at the micro-level derivation is useful as it forces us to be a little clearer about
what is being assumed in the model. Let us turn to the firm's decision, as this brings out the
first problem: namely, whither capital? The only factor we referred to in our model was
labor. Yet, as we know from typical Neoclassical theory, there must be other factors around
which the firm must handle. One of these is capital. Now, since most macroeconomics
operates largely in the short period, we usually sweep capital under the rug. However,
whatever result we get for equilibrium labor employment and wages, there must be some
corresponding equilibrium level of capital and employment and rate of return on capital.
However, if the rate of return on capital is equal to the rate of interest (a common
assumption in equilibrium, otherwise Wicksellian demons are unleashed), then the rate of
interest is determined as the dual in the first line of our earlier catena. Then how does it turn
up again in the third line to be determined by aggregate demand and supply? Is the interest
rate determined in the first line the same as the interest rate determined in the third line?
This is not evident.
However, having said that, we must remember that capital and investment are two different
things (as emphasized by Fisher (1906)): the first is a stock term, the second is a flow term.
Reconciling these has been a perennial headache in economic theory. This difficulty can be
disposed of by one of the following three means. The first is by invoking the principle of
marginal adjustment costs to capital employment. This is alright, but runs up against a little
problem. In particular, if a firm cannot reach its "optimal" amount of capital, then,
conversely, it ought not to hire the "optimal" amount of labor corresponding to that capital

level but rather a different amount that corresponds to the investment level. We are not
guaranteed full employment in this case.
The second resolution is to invoke labor supply growth, so that we can choose optimal
capital-labor ratios, and all investment is merely what is necessary to accompany labor
supply growth. In this case, investment flow is eliminated as a decision separate from the
capital stock decision, and so the problem disappears. This may work better, but then this is
an issue of growth theory, not "macro" theory in the strictest sense.
The third, and simplest, resolution, is to just follow Irving Fisher (1930) and assume all
capital is circulating, i.e. there is no K. The firm's decision is solely based on I and N. Does
this make sense? Indeed, it can, but then we lose the independence of aggregate supply
from the rate of interest (i.e.the aggregate supply curve becomes "upward sloping", rather
than vertical).
Specifically, following Fisher (1930), let us propose that the representative firm faces a
"short-run" production function of the form:
Y = (N, I)
where the output of the fth firm is some function of N, the labor inputs employed by that
firm and investment inputs. It is assumed that the N > 0 and NN < 0, i.e. the marginal
product of labor is positive but diminishing. Similarly, it is assumed that I > 0 and II < 0,
so that we have diminishing marginal product of investment. The profit-maximizing firm
will attempt to increase the difference between total revenue (pY, the sale of output) and
total costs (i.e. total factor payments, wL + (1+r)I where w is the nominal wage and r is the
rate of interest). So, letting denote the profits of the firm, then its problem is:
max = p (N, I) - wN - (1+r)I
This yields us a pair of first order conditions:
p N = w
p I = (1+r)
Now, let us take each in turn. Consider the first one. The term on the left, p N is merely the
marginal value product of labor, so this says that the firm will hire labor until its marginal
value product is equal to the nominal wage. There are two other ways of writing this. A
simple one is to divide by p, so that:
N = w/p
so now the firm hires labor until the marginal productof labor is equal to the real wage,
w/p. Alternatively, we can write it as:

p = w/ N
where the curious term on the right is the marginal cost of output, i.e. the cost of hiring
labor in order to increase output by a unit. To see this clearly, recall that N = dY/dN, so
we can write w/ N = dwN/dY, i.e. the marginal cost of output is the increase in the wage
bill (assuming w is constant, so wdN = dwN) from a unit increase in output. Thus, the
equality above merely says that a firm hires labor (and thus produces output) until the
output price (or marginal revenue) is equal to marginal cost.
Whatever way we look at it, we see that given (w/p), we can determine the amount of labor
demanded by the firm (Nd) via the condition N = w/p, i.e. assuming this is invertible, we
can write the labor demand function as:
Nd = N-1(w/p)
The fact that N > 0 and NN < 0 implies that d N-1/d(w/p) = d Nd/d(w/p) < 0, i.e.that the
firm's labor demand curve is downward-sloping. The aggregate or economy-wide-level
labor demand function is obtained by aggregate firm-level labor demand functions. We
must assume (it is not evident), that these are sufficiently well-behaved so that these
properties are also true for the economy-wide labor demand function.
Let us now turn to investment decision of the firm. We can define p I - 1 in Fisher's
language as the "marginal rate of return over cost", or in more Keynesian language, the
"marginal efficiency of investment", so MEI = p I - 1. Thus, first order condition p I = 1 +
r implies that the firm will employ I (i.e. "invest") until MEI = r, i.e. marginal efficiency of
investment is equated with rate of interest. Notice that as II < 0, then as the rate of interest
rises, then, to equate r and MEI, it must be that investment declines - thus the negative
relationship between investment and interest rate, succinctly, I = I(r) where Ir = dI/dr < 0.
Yet we have been a bit fast and loose with this, as is it makes its seem that the investment
decision is independent of wages and the labor demand decision is independent of the
interest rate. Formally speaking, this will not be the case in this model (and here we enter
into more "Hayekian" ground). To see why, notice what our argument has said: if the wage
rises, then demand for labor falls. But why? When wages rose, the profits of the firm
declined. There are two possible responses a firm can have in order to restore profits:
firstly, by the law the "law of increasing costs", it may have decided to cut output as a
whole, and higher output as a whole implies less labor hired, thus the demand for labor
declines; secondly, by the "law of technical substitution", a firm may not necessarily
change output as a whole, but merely restore profits by changing production methods to a
more capital-intensive technique, i.e. moving away from labor and towards investment -what Hayek (1931) called a "lengthening of the production process".
In general, both these effects will probably come into play in order to explain the decline in
labor demand when wages rise (details on these effects are discussed in our survey of
production theory). In either case, note, the demand for investment goods is affected, so we
cannot say that a rise in wages "only" affects labor demand. It will also affect investment

demand and thus both the aggregate demand and aggregate supply side of the economy.
Similarly, a rise in the rate of interest rate may lead to a reduction in investment demand
and a rise in labor demand, and thus employment. So interest rate also affects both the
aggregate demand and aggregate supply of the economy. The simplistic macromodel we
described earlier does not capture this -- and it is not certain that we are better off now.
In principle, then, when we have a Fisherian investment-labor economy, the first order
conditions for a maximum imply that at the optimum:
N/ I = w/(1+r)
the ratio of marginal products is equal to the ratio of real factor prices (w/(1+r)). The factor
price ratio is shown in Figure 4 as the slope of the isocost line. Once (w/(1+r)) is given, the
firm automatically knows the amount of labor and investment it will undertake (N* and I*)
as the tangency of the highest isoquant and the isocost curve (there is a bit of indeterminacy
here, however; see our discussion of the production decision; we would need to use a
Paretian general equilibrium model to do this properly).

Figure 4 - the Production Decision

At any rate, the main lesson is that labor demand Nd is no longer merely a function of the
wage, but also of the rate of interest, (1+r). Similarly, investment demand I is not only a
function of interest but also a function of the wage rate. The main relationships remain,
however: an increase in w/(1+r), which can be due either to a rise in w or a fall in (1+r),
will usually lead to a decline in labor demand and/or a rise in investment demand (we
qualify this with the term "usually", because there are output effects in this story which may
change our conclusions; see our section on production). At any rate, this implies that we
still obtain a downward-sloping demand function for labor (as a function of the real wage)
and a downward sloping investment function (as a function of the rate of interest). It is just

that now we cannot really isolate them from each other. Finally, we should note that the
microfoundations of production in the Neoclassical macromodel would get even more
complicated if we decided to allow for fixed capital, K, as well. It is for this reason that we
are sticking with the Fisherian circulating capital assumption.
Let us now turn to the household's utility maximization problem. There are three things we
want to obtain here: labor supply, consumption demand and savings. For simplicity, we
will do this in separate steps, but in principle, these decisions are all made together at once.
The labor supply function is derived from an exercise in utility-maximization on the part of
the household. The representative household is assumed to be a rational hedonist - it
attempts to maximize what it can consume and minimize the amount of work it has to do.
Thus, we can posit a utility function for the household, U = U(C, N), where UY > 0 and UN
< 0. UY and UN are the marginal utilities of consuming more goods and supplying more
labor, thus our assumption about signs means that consuming goods, C, is utility-increasing
while supplying labor, N, is utility-decreasing. The assumption of diminishing marginal
utility for nice things implies that the utility function posses the following second
derivatives UYY < 0 and UNN > 0.
An agent buys goods with income obtained from selling his labor on the factor market (a
household can also have endowments of goods or other factors, but we shall ignore that
here), thus it faces two parameters in its constraint: the prices of goods and factors (p, w)
and the factor it is endowed with (the maximum labor supply). Thus, he faces a budget
constraint pC wN. In order to recognize that there is a maximum amount of labor supply
(call it T - a person cannot work more than twenty-four hours a day), we shall change this
constraint by adding the value of maximum labor supply (wT) to both sides so the
constraint can be rewritten:
pC + w(T - N) wT
so the agent sells his total labor supply, T, to buy goods, C and "leisure" (T-N). The budget
constraint is depicted in consumption-leisure space in Figure 5 by the straight line that
emanates from the consumer's endowment, which is at (0, T), with slope -w/p. The agent
maximizes his utility subject to this constraint:
max U = U(C, N)
s.t.
pC + w(T - N) wT
So, setting up a Lagrangian, and solving for the first order conditions for a maximum:
dL/dC = UC - p = 0
dL/dN = UN + w = 0

where is the Langrangian multiplier. This solution can be rewritten:

(-UN)/UC = w/p
i.e. the household will choose between desirable consumption of goods and irksome supply
of labor (or, equivalently, desirable leisure) until the ratio of marginal utilities of each is
equal to the real wage.
This is shown in Figure 5 at point E. Notice, that at the utility-maximizing position E, the
household will choose to supply N* amount of labor (and thus consume (T-N)* amount of
leisure) and enjoy C* amount of consumption. He achieves utility level U(C*, N*) which is
higher than the utility level he would obtain if he was forced to stick to his endowment
(U(0, T)).

Figure 5 - Consumption-Leisure Choice

What will raising the real wage, w/p, imply for the supply of labor, N? The substitution
effect argues that the greater the real wage, the more costly leisure becomes relative to
consumption foregone and thus the agent will supply more labor. The income effect argues
that the greater the wage, the agent can buy the same goods with less work and thus the
more appealing leisure becomes (thus the agents supplies less labor). Thus, it is ambiguous.
Nonetheless, the common reconciliation is to assume a backward-bending labor supply
curve so that at low wages, the substitution effect dominates and at high wages, the income
effect dominates. For simplicity, we shall argue here that the substitution effect dominates
everywhere so that labor supply increases with the real wage.

Let us now turn to the consumption-savings decision, Fisher's (1930) "first

approximation". We wish to obtain the result that C = C(Y, r), i.e. consumption is a
function of income and interest and that CY > 0 and Cr < 0 or, equivalently, as S = Y - C,
then we want a function S = S(Y, r) where SY > 0 and Sr > 0, so savings is a positive
function of interest.
This relationship is derived via intertemporal optimization of consumption on the part of
the household. A two-period illustration of the concept is straightforward. Suppose a
household has a lifespan of two periods, receives income in two periods (Y1, Y2) and must
make a decision on how much to consume in each period (C1, C2). We can thus posit that it
obtains utility from consumption in the form U = U(C1, C2). Although we will not specify a
particular functional form is given, we should note that we normally assume that there is
positive time preference so that a particular amount of future consumption is worth less in
terms of utility than that same consumption amount in the present.
If we have perfectly working financial markets, then the household can lend some of its
present income to increase future consumption or borrow from its future income to increase
present consumption. In the first case, it can curtail present consumption C1 and save an
amount S = Y1 - C1 in the first period and receive it back with interest in the second so that
second-period income is augmented by (1+r)S, i.e. second period income is Y2 + (1+r)S. If
it borrows from the future to the present, all we have to do is consider it "negative" S. Thus,
the household faces the following constraints in each period:
C1 + S Y1
C2 Y2 + (1+r)S
so, solving both for savings and equating them, we can collapse this into one
"intertemporal" constraint:
C1 + C2/(1+r) Y1 + Y2/(1+r)
which can be interpreted as saying that the present value of the stream of consumption
cannot exceed the present value of the stream of income (where, by present value, we see
that future consumption and income is discounted by the rate of interest). This is depicted
in Figure 6 by the straight line emanating from the intertemporal endowment (Y1, Y2) with
slope -(1+r). The household faces the following intertemporal optimization problem:
max U(C1, C2)
s.t.
C1 + C2/(1+r) Y1 + Y2/(1+r)
where, setting up a Lagrangian, we get the following first order conditions:

dL/dC1 = U1 - = 0
dL/dC1 = U2 - /(1+r) = 0
where U1 and U2 are the marginal utilities of present and future consumption respectively.
The solution implies:
U1/U2 = 1+r
i.e. the household will allocate consumption in both periods until the ratio of marginal
utilities is equal to the interest rate (or, in other words, until the desirability of present
consumption relative to the future is equal to the foregone interest). The extrapolation of
Fisher's two-period story to more than two periods is accomplished in the "Life Cycle
Hypothesis" (LCH) of Modigliani and Brumberg (1954).
Figure 6 illustrates the intertemporal optimization problem. Notice that C* is the chosen
intertemporal allocation and Y is intertemporal endowment - thus this individual is a net
saver with savings equal to S = Y1 - C1 > 0. Notice that the utility it attains U(C1*, C2*) is
greater than U(Y1, Y2), the utility it would receive if it had stuck to its original
intertemporal endowment and not saved or borrowed anything at all.

Figure 6 - Consumption-Savings Decision

It is not difficult to see that present consumption falls when the rate of interest rises. In
other words, as interest rate rises, there is an incentive to save more (i.e. reduce
consumption today further in favor of consumption tomorrow). Naturally, there are income

effects that need to be accounted for, but we shall presume that this substitution effect
dominates. Thus present consumption, C1 is negatively related to the rate of interest, r.
Thus, in our general consumption function, C = C(Y, r), we have it that Cr < 0 or
equivalently, S = S(Y, r) and Sr > 0, which is exactly what we wanted.
(D) Some Difficulties
It seems that the Neoclassical macromodel stands firm on its own foundations - or does it?
We have already hinted at a few problems, let us pursue these for the moment. To see the
first difficulty, let us "close" the model by placing all the markets together in one gigantic
Walras's Law constraint (we are suppressing prices):
(Md - Ms) + (Bd - Bs) + (Yd - Ys) + (Nd - Ns) = 0
where we have represented four market: money, bonds, goods and labor respectively. They
must add up to zero by Walras's Law. We could represent (Yd - Ys) as (I - S) as they are
equivalent (assuming government's budget is balanced).
The Neoclassical story is then as follows: w/p clears the labor market (so (Nd - Ns) = 0), the
price level clears the money market (so (Md - Ms) = 0), leaving the interest rate to clear the
goods market (so (Yd - Ys) = 0) and hence, residually by Walras's Law, the interest rate
clears the bond market as well (so (Bd - Bs) = 0). All is fine in the Neoclassical kingdom.
But this statement allows all markets to affect each other: if there is excess demand in the
goods market (Yd > Ys), then somewhere something must be in excess supply. This is
simple Neoclassical logic: if something more is demanded and nothing else is supplied,
then that demand must come from some deficiency in demand somewhere else. Thus
market disequilibria spill over into each other.
However, by assumption of dichotomy between money and real sides, we cannot have it
that money market disequilibrium affects anything. Thus, we need it that (Md - Ms) = 0 at
all times. Thus, the Walras's Law constraint is reduced to:
(Bd - Bs) + (Yd - Ys) + (Nd - Ns) = 0
which is what Oskar Lange (1942) and Don Patinkin (1956) defined as "Say's Law", i.e. the
demand for "real" things must equal the supply of "real" things, with no spillovers into the
nominal things such as money.
Is this a problem? Yes. We have eliminated the manner in which we get the determination
of the price level from the money market. Fisher, Pigou, Cassel and company assumed that
the price level would adjust by standard Neoclassical market-adjustment arguments and
thought no further about it. But the "standard arguments" in Neoclassical theory rely on the
concept of substitution between items - i.e. spillovers into other markets. Yet there is no
substitution here because the money market is completely isolated from all other markets:
money demand is "fixed" from outside and nominal money supply is also fixed. If money

demand, for some reason, is different from money supply, there is no straightforward
process of "substitution" that leads to the change in price level. The equilibrium condition,
L(r, Y) = M/p or Md = Ms is, by the dichotomy assumption, a permanent condition that
applies at all times.
The problem with this is not only do we not know how the price level is supposed to adjust,
but then the price level is actually indeterminate. If money demand always equals money
supply, then the price level can be anything -- the money market will still clear.
Furthermore, as Patinkin (1956) argues, the mechanisms of the Quantity Theory are
violated. How? The Quantity Theory argued that if money supply rises, then prices would
rise and the original Fisher (1911) argument was that the excess supply of money led to an
excess demand for goods and that would raise prices which would in turn reduce the real
supply of money. As excess real money supply fell, excess demand for goods would also
fall. The new equilibrium would arise with output unchanged, but price level higher. But if
money market is prevented from spilling over into the goods market - as the imposed
dichotomy implies - how is this process supposed to happen?
This failure was pointed out by Patinkin (1948, 1956) who made the necessary corrections
in the Neoclassical model to account for it. His correction was done by violating the
dichotomy argument directly. We need nominal variables to somehow affect aggregate
demand. He proposed this via a "real balance" or "wealth" effect on consumption.
Patinkin's argument was that real money balances, M/p, enter the consumption demand
equation so C = C(Y, r, M/p). An increase in the money supply increases real wealth (M/p),
which thereby increases C and consequently Yd -- that gives us the necessary excess
demand for goods to make the Quantity Theory work: with excess goods demand unmet,
the prices for all goods rise, M/p falls back down and so does C and Yd back to Y.
Neutrality still holds, but dichotomy is broken.
Nevertheless, let us presume now that the money market does clear nicely. A second
difficulty nonetheless arises. Consider the possibility of goods demand being so low that it
intersects aggregate supply at a negative interest rate. In principle, negative prices are
difficult to fathom in general so, in principle, the argument is usually made that the good in
question becomes "free". In other words, if the demand and supply for peanuts intersect at a
negative price, then we impose the "complementary slackness" condition that price of
peanuts is zero, and thus we have, in "equilibrium", an excess supply of peanuts, i.e.
peanuts are free.
That is alright for a single good, but in the case of goods market, a negative interest rate
cannot be rescued by assuming that interest rates are zero and thus "all goods are free". The
implication is that if aggregate demand is low enough, the entire economy would be "free".
Patinkin (1948) also envisaged that the real balance effect would save Neoclassical
macroeconomics from this possibility: the excess supply of goods at zero interest would
spillover into an excess demand for money. This would lower the price level and thus lead
to an increase in real money supply. By the real balance effect, aggregate demand would
rise again - bringing us back into positive interest (and thus an appropriately "non-free"
economy).

A third problem arises when examining our Walras' Law constraint. Suppose the interest
rate clears the goods market, but, concurrently, that we still have an excess demand for
bonds. This is possible - but it would imply we had an excess supply of labor. Thus, we can
have unemployment even when the goods market clears if we allow spillovers from bond to
labor markets. Thus, we can have "too high" interest rates (for the bond market) and "too
high" wages simultaneously. Does this make sense? This is not very intuitive - as it implies
that firms are somehow substituting labor for bonds. This is not insensible if we think of a
firm somehow deciding to use their wage payments to purchase bonds instead (because
they offer a "higher return" or something), but the intuition disappears once we ask why
firms are reducing their demand for labor when the rate of return on bonds is already "too
high"? What does this mean for capital-labor substitution? The intuition is not clear, but it
is mathematically allowable in the Walras's Law constraint.
Furthermore, if the goods market is in equilibrium but the bond market is not (spilling over
into labor), what is the rate of interest which equilibrates both bonds and goods? What are
the mechanics implied here? An excess supply of bonds can only be moved back to
equilibrium if the interest rate falls, but the interest rate will not fall if the goods market is
in equlibrium. What now? If alternatively, we had such a large excess supply of labor so
that both bonds and goods markets were in excess demand, then we would be
simultaneously saying that the interest rate is expected to rise (from the goods market
disequilibrium) and it is expected to fall (from the band market disequlibrium). Is this
contradictory?
One can suspect that these peculiar predicaments might lie in the fact that the Neoclassical
model places together, in the same constraint flows (goods and labor demands) and stocks
(bond demands). This could be corrected by simply realizing that they cannot be together as
they have different time references. However, many economists - notably John Hicks
(1939) and Don Patinkin (1956, 1958) - are adamant about "everything depending on
everything else" and permitting stocks and flows to be in the same constraint by just
adjusting a little bit. Hicks does make a point to speak of loanable funds entering the
constraint in the form of flows (i.e. "lending and borrowing", thus "credit" instead of
"bonds") but this does not remove the difficulty of contradictory interest rate movements in
the case of an excess supply of labor.
Lawrence Klein (1950) however, enters the fray here and surprisingly concludes that
actually the bond/credit market has absolutely nothing to do with the rate of interest. The
rate of interest, he claims, is determined by investment and savings, period. All the credit
market does is determine the price level. This is a bold statement, but if we accept it, then
what role remains for the money market?
There are two resolutions. The simplest is to claim that we were wrong to differentiate
between the credit/bond market and the goods market to begin with. In other words, we
placed them separately in the Walras's Law constraint, but that this was illegitimate. Goods
demand is bond supply by definition and goods supply is bond demand by definition. There
is no "mutual mechanism" between them. The interest rate is determined in one place
alone: the goods market. The bond or credit market (stock or flow) is merely another term

for "goods market" - they are one and the same thing. Thus, we either include the goods
market or the bond market in the constraint, but not both simultaneously.
This resolution is not particularly troublesome since we introduced bond demand and
supply in precisely this manner. But while it is not counterintuitive, it is not that obvious
either: the demand and supply of credit can indeed be reconciled with investment and
savings, but are they really the same thing exactly? If so, then we would be arguing in the
"real funds" framework of Fisher's (1930) theory, but have precluded the plausible
Wicksellian modifications brought in by Robertson (1937, 1940) and Ohlin (1937).
A second resolution is to follow Sargent (1979) and remove the simultaneity implied in our
Walras's Law constraint and deal with the model in a block recursive form. In short, we
impose two Walras's Law constraints, namely:
(Nd - Ns) = 0
(Bd - Bs) + (Yd - Ys) = 0
so that the bond/goods market determines the interest rate and the labor market determines
the real wage rate alone. The interest rate, then, is argued to be absolutely determined by
the bond market - and so, as the previous analysis insinuates, bond and goods markets are
both equilibrated by a single, common interest rate. However, the problem arises that now
the labor market must clear at all times (no disequilibrium being implied by the constraint)
and thus, analagously with the problem we faced in the money market, the real wage
becomes indeterminate!
The way out of this would be to include capital - which is what labor substituted for in the
first place, was it not? That long-forgotten, out-of-the-system variable must now be
included again. In this case, we must rewrite the system as follows:
(Nd - Ns) + (Kd - Ks) = 0
(Bd - Bs) + (Yd - Ys) = 0
so the equilibrating mechanism between the factors is (w/p)/r, the ratio of factor returns. In
this case, the real wage is still indeterminate, only relative factor returns are determined in
equilibrium. But we can now pin down the real wage by recognizing that r falls out of the
second bond/goods constraint. Thus, second constraint can be used to pin down a value for
r which will, in turn, pin down a value for (w/p). The first equation gives us (w/p)/r, the
second r, so using all this, we can determine (w/p) exactly. If, in addition, we can also pin
down p in the money market (somehow), then we would have the additional benefit that the
nominal wage (w) would also be determinate. The system, then, would become entirely
solvable.
Or is it? Now we have capital stocks again - and again we must be careful of its relationship
with investment. Recall that investment is positive only if capital is not at its optimal level,

K* (otherwise there would be no point in investing). Imposing the adjustment cost story
does not solve things entirely: in a period where investment is positive, capital would be
below optimal capital stock. By the microeconomic theory of the firm, the cost-minimizing
choice with capital constrained below K* would be that labor demand would be above
optimal labor, L* at the given real wage rate. In fact, a simple isoquant exercise could
demonstrate that with constrained capital stock, labor is hired where L/ K < (w/p)/r so
that the real wage is actually too high! So much for factor-side equilibrium. As long as
investment is positive, things go awry in the factor markets.
Attempts at resolutions have been made in investment theory, but they have not been
solved to everyone's satisfaction. However, the incorporation of growth theory of the
Solowian brand in Neoclassical macromodels has enabled modern macroeconomists to
largely circumvent this problem. Note that if labor is growing at some "natural rate", then
this "disequilibrium" arising from stock-flow confusion is eliminated almost completely as
movements in capital will be accompanied by movements in labor. Thus, we can speak of
steady market clearing factor prices and an optimal capital-labor ratio which can be largely
reconciled with investment flows. It is a simple maneouvre, but one the old Neoclassicals
did not really come up with. The cost of incorporating growth is that the idea of
"investment" as an independent behavioral phenomena becomes gradually eclipsed by
complete determination by household savings and growth - making rich financial markets
and independent firm investment decisions an almost superfluous consideration.
In sum, there are particular problems in the formulation of the static Neoclassical model as
we have presented it. Of course, one may argue, together with John Hicks (1939: p.154),
that these are not real issues: in a general equilibrium system, real wages, interest rates,
prices and quantities will be determined somehow, it does not particularly matter where.
While this may be true, it does not lend us any insight into the workings of the
macroeconomy. What is specifically of interest here is whether interest rates or real wages
or whatever equilibrate particular markets. Furthermore, we must note that we are
describing a rather simplistic Neoclassical system rather a fully-fledged Walrasian general
equilibrium system. Both share the most important features of Neoclassical economics, but
there are important points of departure between these as well.