Keynesian Economics and the Pigou and Friedman Curves

So it seems that we have a model that can explain "unemployment" as an economic "equilibrium" in some sense. Economists are still arguing over whether the model is really sound or not, but in its own terms, it does give an explanation of unemployment in terms of insufficient aggregate demand.

In an earlier chapter we took a first-guess look at a model of unemployment, production and inflation. Recall the elements of that approach:

Pigou Curve: The Pigou Curve is a curve that shows the relationship between the rate of inflation and the growth of GDP, showing each respective inflation rate and the growth in the quantity of goods and services that people want to buy.
Friedman Curve: The Friedman Curve is a curve that shows the relationship between the rate of inflation and the growth of GDP, showing each respective inflation rate and the growth of real GDP that businessmen are willing to sell at that price level.

How does the Keynesian approach fit in? Since the Keynesian approach is a theory of aggregate demand, it should tell us something about the Pigou Curve. What it tells us is negative. According to the approach in this chapter, the quantity of RGDP people want to buy depends on investment, consumption and the multiplier -- and not on the price level at all. In the example we went through in this chapter, the aggregate demand is 5000 billion, regardless of the price level. By that reasoning, the Pigou Curve would be vertical, as shown in Figure 8:

Figure 8: FC, PC and Keynesian Equilibrium Output

Of course, Keynes knew the aggregate demand would not always be independent of the price level. But he thought it would be a good approximation, especially in the conditions of the 1930's when he was writing. A. C. Pigou had already given some reasons why the Aggregate Demand Curve would probably be downsloping (that's why I call the Pigou Curve after him) and Keynes argued that they would not have much impact in the circumstances of the 30's. In making that argument, Keynes clarified Pigou's ideas as well as criticizing them, filling any many details Pigou had left blank. That's how controversy can often be productive in economics.

Next: Chapter Summary