Academic journal article Atlantic Economic Journal

A Note on Wealth in the Money Demand Function and Aggregate Demand Elasticity

Academic journal article Atlantic Economic Journal

A Note on Wealth in the Money Demand Function and Aggregate Demand Elasticity

Article excerpt

It is well-established in macroeconomic theory that, for a closed economy analyzed with the neoclassical IS-LM framework where normal conditions prevail in both the commodity and money markets, the Pigou effect reinforces the Keynes effect and causes the aggregate demand curve to be more elastic with respect to the general price level. The Pigou effect, of course, results when a price-induced change in real wealth changes both consumption spending and the IS curve. While numerous economists have examined, both theoretically and empirically, the role of real wealth in the money demand function, none to our knowledge has investigated the impact of this on aggregate demand elasticity within a flexible-price IS-LM system. The purpose of this note is to explore how the price level elasticity of aggregate demand is affected by the inclusion of real wealth as an argument in the money demand and LM functions.

To begin, let a given price level and an assumed level of nominal wealth establish the positions of the IS and LM curves. This, in turn, determines the initial equilibrium level of demand-side real income and, correspondingly, one point on the economy's aggregate demand curve. Now let the price level rise.

In the standard comparative static analysis, equilibrium real income decreases for two reasons. The Pigou effect shifts the IS curve in the same direction, left, that the Keynes effect shifts the LM curve, flattening the aggregate demand curve and increasing its price level elasticity. …

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