Disequilibrium Dynamics of the Monetary Economy: A Micro-Founded Synthesis of the Wicksellian Theory of Cumulative Process and the Keynesian Theory of Effective Demand

Abstract

The present article is an attempt to reconstruct a macro-dynamic theory of the monetary economy on the basis of the theory of monopolistically competitive firms formulated as a micro-foundation for the decentralized price mechanism. It shows how the micro-founded theorization of the very foundation of Classical economics – the decentralized price mechanism – actually undermines the entire structure of Classical economics. The paper establishes the following propositions. (1) If monopolistically competitive firms are free to adjust their prices, their ex ante expectations for the average price are necessarily falsified by the very aggregate outcome of their own decentralized price decisions unless aggregate demand gap happens to be zero. Once the aggregate demand gap deviates from zero, the firms’ simultaneous attempt to rectify their errors in expectations triggers a Wicksellian cumulative process that drives the average price further away from equilibrium. (2) In contrast, if prices are sticky with an exogenous probability, any value of aggregate demand gap becomes compatible with firms’ simultaneous rational expectations and the economy settles to one of infinitely many globally stable steady-states with Keynesian properties. (3) If the price stickiness itself is endogenized in the sense that each firm optimally balances adjustment costs of changing the price and opportunity costs of not changing the price, the economy exhibits a strong nonlinearity in its dynamical behaviors. As long as the aggregate demand gap remains within a band, the firms are able to enjoy rational expectations and the economy tends to be globally stable. Once, however, the aggregate demand gap jumps out of the band, rational expectations become unattainable again and the economy sets off a globally unstable cumulative process. Moreover, there should be a fundamental regime-change in the ways monetary policy should be conducted between when the aggregate demand gap stays within the band and when it strays out of it. (4) Finally, as long as prices are costly to adjust, the aggregate rate of involuntary unemployment never shrinks to the natural rate, and as long as adjustment costs are lump-sum and higher for price reduction than for price increase, the Phillips curve never loses its negative slope even in the long-run.

Keywords: Disequilibrium Dynamics, Monetary Theory, Monopolistic Competition, DSGE, New Keynesian Economics, Rational Expectations, Phillips Curve, Inflation, Deflation, Sticky Prices, Control Band Policy, Cumulative Process, Effective Demand, Wicksell, Keynes

JEL Classification: D43, D50, D84, E10, E12, E24, E31, E32, E42, E52