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Market Clearing

Market Clearing

BIBLIOGRAPHY

The concept of market clearing related initially to the capability of the aggregate economy to generate sufficient purchasing power to assure that the economys aggregate output will find purchasers. When this is the case, the total value of the economys output will be exactly equal to the total value of the economys purchases. In short, the economys aggregate demand will be the equivalent of aggregate supply so that a situation historically termed a glut of output will be nonexistent.

Concern about the possibility of a glut dates (at least) to late-eighteenth-century France, where production was directed by central authority toward luxury products intended for export (for example, tapestries, crystal, velvet) in order to increase the economys ability to earn gold via trade. The fear that French purchasing power could become insufficient was quelled by the articulation of a generalization by Jean-Baptiste Say in 1803 that became known as the Law of Markets. It maintained that, because the value generated by the process of production simultaneously generates an equivalent flow of factor payments, an insufficiency of purchasing power is impossible because supply creates its own demand. The logic of Says argument was introduced into England by John Stuart Mill in the mid-nineteenth century and continued to dominate academic thinking until the mid-1930s, as Ingrid Rima notes in her 2001 work. Traditional nineteenth-century thinkers concerned themselves primarily with the problems of value and distribution and the equilibration of competitive markets, although they also understood that monetary expansion could result in inflation. The argument that purchasing power in the aggregate economy might be deficient was largely the province of monetary reformers who were unaware that Says Law was predicated on a barter interpretation of the aggregate economy so that money served simply as a convenience to facilitate exchange.

It was not until the depressed 1930s that attention was focused on the linkage between changes in monetary aggregates and changes in real economic activity. John Maynard Keynes wrote his The General Theory of Employment, Interest, and Money (1936) to challenge Says Law on the ground that it is inapplicable to a monetary production economy: Says Law is not the true law relating the aggregate demand and supply functions (p. 26), because in a monetary economy the aggregate demand function does not coincide with the aggregate supply function. In particular Keynes maintained that it is the part played by the aggregate demand function that has been overlooked (p. 89). Thus his theory focused on the components of aggregate expenditures, emphasizing the stable relationship between consumption and income and the great instability of investment expenditures in consequence of the inherent uncertainty of the marginal efficiency of capital (Davidson 1972) relative to the rate of interest paid for funds, whether these are borrowed or internally generated (Minsky 1982). The argument that followed was when aggregate effective demand falls short of the economys resource capability (given the level of technical knowledge), the demand deficiency is evidenced principally in the involuntary unemployment of some part of its workforce (Keynes 1936; Weintraub 1966). Thinkers who responded positively to Keyness argument looked to fiscal policy, that is, reduced tax collections and increased government spending financed via bond sales to increase aggregate spending via the operation of the multiplier, which was expected to enable both commodity and labor markets to clear at a higher income level. The persuasiveness of the theory of aggregate demand culminated in the Keynesian revolution, which shifted economists perspectives to the behavior of the economys macroeconomic magnitudes. The shift underscores the distinction between the market equilibrium of industry demand and supply curves and market clearing in the sense of equivalence of aggregate demand and aggregate supply, in which full employment was shown to be the economys normal equilibrium state.

It is perhaps not surprising that the ink of The General Theory was hardly dry before John R. Hicks of Oxford University wrote Mr. Keynes and the Classics: A Suggested Reinterpretation (1937), in which he maintained that the criticism of indeterminacy that Keynes made against the classical theory of interest was equally the fault of his own liquidity preference theory. Hickss reinterpretation suggested that by joining liquidity preference to abstinence theory, which he represented in terms of two new curves, the IS and the LM curves, it can be shown that savings are a function of both income and the interest rate. The intersection of the IS curve and the LM curve, which brings together the four variables of the interest rate problem, the savings function, the investment function, the systems monetary stock, and the liquidity preference function, will make the interest rate determinant. Thus Hicks and the Harvard professor Alvin Harvey Hansen (1953) integrated the general equilibrium approach introduced by Leon Walras in the 1870s to demonstrate mathematically that all markets are interdependent and simultaneously able to clear goods and factor markets via the guidance of an auctioneer through whom participants re-contracted until mutually satisfactory trades could be consummated. Thus began a counterrevolution against Keynes (sometimes called neo-Walrasianism) that reasserted the market clearing capability of an economy characterized by flexible wages and prices (Patinkin 1956). In a 1956 model that also incorporated the labor market, Don Patinkin maintained that Keynes did not adequately recognize the significance of price changes on the real value (that is, the purchasing power) of monetary balances and wealth as a mechanism for restoring commodity, bond, and labor market equilibriums with full employment. In effect the integration of Walrasian foundations onto Keyness model, whose foundation is Marshallian, undermined the Keynesian revolution.

It was to address neo-Walrasianism challenges to Keyness credibility that Robert Clower (1965) and Axel Leijonhufvud (1967) undertook reinterpretations of Keyness General Theory as a disequilibrium problem attributable to information and coordination failures. They argued that markets clear when potential traders successfully make the adjustments needed for market clearing instead of lagging behind. The theoretical contributions of Clower and others underscored the inadequacy of the micro-foundations inherent in the so-called Keynesian framework. Their efforts encouraged an increasingly elaborate micro-approach to rationalize sticky wages and prices in efficiency terms (Barro and Grossman 1976). The essential research focus for many Keynesian economists thus became to identify the reasons for ongoing wage and price rigidities that impede market clearing and to explain the successes and failures of coordination or its absence (Weintraub 1979).

BIBLIOGRAPHY

Barro, Robert J., and Herschel I. Grossman. 1976. Money, Employment, and Inflation. New York: Cambridge University Press.

Clower, Robert. 1965. The Keynesian Counter-Revolution: A Theoretical Appraisal. In The Theory of Interest Rates, ed. Frank H. Hahn and Frank P. Brechling, 103125. London: Macmillan.

Davidson, Paul. 1972. Money and the Real World. 2nd ed. London: Macmillan.

Hansen, Alvin Harvey. 1953. A Guide to Keynes. New York: McGraw-Hill.

Hicks, John R. 1937. Mr. Keynes and the Classics: A Suggested Reinterpretation. Econometrica 6: 147159.

Keynes, John Maynard. 1936. The General Theory of Employment, Interest, and Money. New York: Harcourt, Brace.

Leijonhufvud, Axel. 1967. Keynes and the Keynesians: A Suggested Reinterpretation. American Economic Review 57 (2): 401410.

Minsky, Hyman P. 1982. Can It Happen Again? Armonk, NY: Sharpe.

Patinkin, Don. 1965. Money, Interest, and Prices. 2nd ed. New York: Harper and Row.

Rima, Ingrid Hahne. 2001. Development of Economic Analysis. 6th ed. London and New York: Routledge.

Weintraub, E. Roy. 1979. Microfoundations. Cambridge, U.K.: Cambridge University Press.

Weintraub, Sidney. 1966. A Keynesian Theory of Employment Growth and Income Distribution. Philadelphia: Chilton.

Ingrid H. Rima

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