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other things and tend to raise their prices. (It would do so, anyway, unless an
inelastic demand for blankets and flexibility of their price caused the total
exchange value of the increased stock to be less than the stocks value before
its increase.) The auctioneer makes blankets just as usable as money in paying
for things bought and in serving as a reserve of ready purchasing power.
Whether a good fairy added $1 billion worth to a countrys stock of blankets
or gave its inhabitants $1 billion of new money, demands for (other) commodities would respond in the same way. Yet the form of the gift is relevant
to behavior in the real world. A nonmonetary gift could quite conceivably have
a contractionary effect because peoples additional wealth would increase their
desired holdings of money. Chapter 4 deals explicitly with this possibility.
A properly formulated budget constraint for the real world recognizes the
requirement that money be offered or demanded as one of the commodities
entering into every trade (Clower, 1967 [1984], p. 86). It recognizes a clear
separation between (1) offering to sell commodities and take money in exchange
and (2) offering to buy commodities and pay money for them. (Compare the two
stages of exchange mentioned on page 99 above.) The first branch of the budget
constraint, called the income constraint, specifies that the sum of prices times
quantities of commodities offered equals the amount of money desired in
exchange. It recognizes that all (net) offers to sell commodities involve, in the
first instance, a desire to acquire just one other thing, money. The second branch,
the expenditure constraint, specifies that the sum of prices times quantities
of commodities demanded equals the amount of money offered in exchange.
It recognizes that demands for commodities count on the markets of a monetary
economy only if desires are backed up by readiness to pay money money
obtained by selling commodities in our broadened sense of the term, which
includes bonds.
An individuals plans might satisfy his unified budget constraint yet fail to
satisfy his more realistic split constraint. For example, his intended sales might
cover his intended purchases, leaving his cash balance unchanged. If some of
his intended sales fell through, however, he could not use the unreceived money
to cover his intended purchases.

IMPAIRED SIGNALS AND CONTAGIOUS

DISEQUILIBRIUM
In a model that realistically recognizes the use of money in substantially all
transactions, increased initial endowments of some commodities do not directly
increase the demands for other commodities. As the splitting of the budget
constraint recognizes, supply of some commodities constitutes demand for

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others only if the commodities supplied are sold successfully for money with
which to demand the others. No deficiency of aggregate demand exists
provided that no monetary disequilibrium is obstructing the intermediated
exchanges of commodities for commodities. Clowers analysis directs attention
to this crucial proviso (compare the discussion in Chapter 1 of the goodsagainst-goods approach).
A hitch involving money impairs the communication mechanism of the
market. Clower might want to supply his services indirectly or directly for
champagne, yet run into difficulty informing producers of his willingness to
solve their market research problems in exchange for copious quantities of their
excellent beverage (Clower, 1965 [1984], p. 48). More generally, workers
might want to buy more consumer goods if only they could get jobs, and firms
might want to hire more workers if only they could sell more consumer goods,
yet both sides might run into difficulty in signaling and accomplishing these
desired exchanges.
Here is the place for a broad, intuitive summary. Traditional Walrasian
general-equilibrium theory tacitly supposed, in each supply or demand function,
that markets cleared for all items except the one in question. (The clearing of its
own market was neither assumed nor denied, since the necessary conditions
were under investigation.) The theory assumed that the individual transactor
could succeed in buying or selling things at market-clearing prices in whatever
amounts he desired, as described by his demand and supply functions. His
demand functions (and factor-supply functions) did not have to include his
income specifically as an independent variable, since its equilibrium level was
already implicitly specified by the market prices of factors and his own factorsupply functions (as well as whatever accounted for his share of business profits).
This theory committed a serious oversight. Some of the prices confronting
the individual (for example, the price of his labor) may be disequilibrium prices
at which he cannot deal in the quantities he desires. If so, his effective demand
and supply functions diverge from the notional ones traditionally written. In a
situation of generally deficient effective demand (interpreted here as one in
which prices and wages are generally too high in relation to the nominal quantity
of money), real incomes are lower than what the Walrasian general-equilibrium equations (implicitly) indicate. Because disequilibrium constrains real
incomes, effective demands for most commodities are weaker than they would
be in general equilibrium.
This formulation alludes to what Clower calls the income-constrained
process, the process of cumulative disequilibrium. When disequilibrium prices
constrain sales and therefore production of particular commodities, their
producers by that very token suffer cuts in real income. These producers
effective demands for the outputs of other sectors of the economy are accordingly weaker than their notional demands. With demands weakened, what might

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have been market-clearing prices for the products of these other sectors are
now too high, and prices already too high are now still further above equilibrium levels.3 The drop in sales, output and real incomes in these other sectors
reduces demands for and production of the outputs of still other sectors, and so
on cumulatively. In short, the drop in production in the sectors first thrown out
of equilibrium spells a drop in real buying power and in the real demand for the
outputs of other sectors, which suffer in turn. And so on.
In the reverse direction, revival in some sectors constitutes increased buying
power over the outputs of other sectors. Even if left unchanged, prices of those
other outputs are now less excessive in relation to their market-clearing levels
than they were before. Recovery spreads still more widely.
The cumulative character of recession and recovery is an element of truth
that the mechanistic Keynesian multiplier distorts. Multiplier formulas convey
a spurious impression of precision. They draw attention away from the role of
prices. Degrees of disequilibrium, of its pervasiveness, and of the wrongness
of prices are inherently fuzzy. Little warrant exists for simply assuming
dependable quantitative relations in these matters.

MONETARY CONTRACTION: THE MODEL OF BARRO

AND GROSSMAN
Gordon (1990b, p. 1138) contrasts the inconsistencies in new Keynesian
economics with the work of Barro and Grossman (1971, 1976) in particular.
Their work illuminates what determines quantities of output and employment
when prices and wages are sticky. Emphasizing constraints and spillovers
among markets that fail to clear, they merge the complementary theories of
Clower (1965 [1984]), and Patinkin (1965, Chapter 13). Clower argues that
workers demand for commodities is constrained by their success in selling
labor, while Patinkin argues that firms demand for labor is constrained by their
success in selling commodities.
Patinkins Chapter 13, which focuses on the causes of involuntary unemployment, foreshadows much of the disequilibrium theory developed by
Clower, Leijonhufvud and Barro and Grossman. Patinkin recognizes that involuntary unemployment does not presuppose an excessive and rigid real wage
rate and that cutting real wages may be neither necessary nor sufficient for
restoring full-employment equilibrium. What follows helps explain the logic
behind these observations.
At the analytical core of Barro and Grossmans book of 1976 is their
assumption that nominal wages and prices respond sluggishly if at all to shifts
in demand. Markets can fail to clear. If disequilibrium prices and wages are

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restricting possibilities of exchange, then output and employment do depend

on aggregate demand. A deficiency of demand for commodities depresses
employment through a multiplier process. Clowers distinction between
effective and notional demand and supply functions becomes relevant.
Employment can be depressed even if the real wage rate remains fixed at its
full-employment equilibrium level. A decline in the effective demand for commodities reduces the effective demand for labor, and these shifts do not
presuppose a rise in the ratio of wages to prices. Money prices and wages might
both be too high, even in the same degree, in relation to the nominal quantity
of money.
If exchange is voluntary, actual transactions in a good are whichever is
smaller, the demand quantity or the supply quantity. Failure of a market to clear
spells frustration for parties on one side or the other and constrains their ability
to deal in other markets. Most obviously, a person frustrated in finding a job is
constrained in buying consumer goods.
In reality, opportunities to build up and run down inventories dampen the
contagion of disequilibrium. To focus attention on that contagion, however,
Barro and Grossman assume that firms do not hold inventories.
In the case of general excess supply (deficient demand), firms are producing
less output than they would want to produce and sell at going levels of prices
and wages. They are employing less labor than they would want to employ if
they were meeting no frustration in sales. Firms actual output is smaller than
their notional supply quantity, so their effective demand for labor is smaller
than their notional labor-demand function indicates. Households, selling less
labor than their notional supply, are effectively demanding fewer commodities
than their notional functions would indicate.
The constraints on firms sales of commodities and so on their demands for
labor (compare Patinkin) and the constraints on households sales of labor and
so on their demands for commodities (compare Clower) interact and reinforce
each other. This process of interaction and reinforcement, akin in a way to a
Keynesian multiplier process, does not go so far as to reduce economic activity
to zero. Instead, production, consumption and employment settle at a quasiequilibrium below full employment, as explained in Chapter 3.
To help make the point that households will adjust to their current constraint
on earning incomes not entirely by curtailing current consumption but partly by
other adjustments also, Barro and Grossman introduce distinctions between
different spans of time. We omit these details here.
We now consider the process determining actual income and employment.
We suppose that wages and prices are initially consistent with full-employment
equilibrium, but that some exogenous disturbance such as a decrease in the
nominal quantity of money renders their unchanged levels too high now. As
the Wicksell Process unfolds, households meet frustration in selling labor, firms

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in selling commodities. The fall in labor earnings (and in households share in

business profits) causes households to reduce further their effective demands
for commodities. At the same time, the reduction in effective demand for and
sales of commodities further reduces the profits of firms and their effective
demand for labor. The cumulative decline persists until the actual levels of
output and employment settle below their full-employment levels.
To look at the process in a somewhat different way, real output and income
deteriorate until the quantity of money actually (effectively) demanded as cash
balances, as distinguished from the quantity that would be demanded at full
employment, no longer exceeds the actual money supply. If, as we are
supposing, no cuts in nominal wages and prices reduce the nominal demand
for money, then real activity must deteriorate to reduce the quantity of money
that people feel they can afford to hold. As argued in Chapter 3, however, an
effective transactions-flow excess demand for money still persists in the quasiequilibrium as workers are frustrated in supplying labor and firms are frustrated
in supplying commodities. Disequilibrium actually prevails.
The stickiness of prices and wages poses obstacles to prompt adjustment that
are understated by the slight degree of disaggregation into commodities-ingeneral and labor-in-general that Barro and Grossman consider. In the very
finely disaggregated real world, problems of information and of piecemeal decisionmaking go far toward explaining the sluggishness of price and wage
adjustments, as explained in Chapter 7.
Figure 6.1 portrays the case of generally deficient demand. Employment is
measured along the horizontal axis, real output along the vertical. Dashed lines
perpendicular to the axes indicate employment and output at full employment
and meet at point A. The curve labeled Firms represents a physical relation,
the production function. Its diminishing slope reflects the diminishing marginal
productivity of labor. In the present case of deficient demand, the curve shows
the volume of commodities demanded required to motivate employing the corresponding amount of labor. Because of the diminishing marginal productivity
of labor, the contemplated demand for commodities required to motivate each
contemplated increment in employment rises less and less. In the present case,
then, the curve for firms shows volumes of output associated with both effectively demanded and actually employed amounts of labor. (We ignore here the
question of whether real balances belong in the production function and whether
the decrease in cash balances would shift it.)
A curve for households, drawn dashed, shows the association between
amounts of labor supplied and commodities demanded, given a full-employment
real quantity of money. The solid curve for households also shows the demand
for commodities arising from indicated amounts of actual employment. Its
being drawn lower than the dashed curve shows the actual demand schedule for
commodities depressed because real money balances are now inadequate for full