Abstract
“Traditional” economic theory is largely concerned with the definition of the set of relative prices which in given conditions of tastes, knowledge and resources, will “clear the market,” leaving neither excess demand nor excess supply—neither bottlenecks nor unemployment—anywhere in the economy. In the fish market or the auction room—wherever the market forces can be observed most clearly and freely at work—the free rise on fall of prices can be seen to bring demands and supplies into equilibrium. It seems, therefore, a short step to the proposition that a free and flexible pricing system will automatically tend to establish all prices in their equilibrium relationship.
Review of Price Flexibility and Employment, by Oscar Lange. Cowles Commission Monograph No.8. The Principia Press, Inc., Bloomington, Indiana, 1944, pp. ix, 114. Trevor W. Swan, 1945b, “Price Flexibility and Employment”, The Economic Record 21, (December), 236–253.
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Notes
- 1.
Value and Capital, Chapters XX to XXII.
- 2.
The elasticity of expectations is defined (following Hicks, Value and Capital, p. 205) as the ratio of the proportional increment of the expected price to the proportional increment of the current price. “Expected prices must be interpreted” as discontented effective expected prices (Lange, pp. 27‒28 and 31‒32). Zero intertemporal substitution therefore requires not only prices expectation of unit elasticity, but constant interest rates and “risk premiums”. If elasticity differs ag between different goods or different future dates, Lange uses the concept of “prevailing elasticity” (pp. 22‒73).
- 3.
More strictly, Lange speaks of “intra-temporal substitution and expansion”, thinking usually in terms of a fall in the relative price of a factor, which leads to its substitution for other factors, now relatively dearer, and an expansion of the output of products using it, their marginal costs having fallen in relation to their prices. Lange’s “substitution” and “expansion” effects should not, of course, be confused with Hicks’ “substitution” and “income” effects, although they have something in common. It is apparently assumed throughout that “income” effects go in the same direction as “substitution” effects, and that “complementarity” can be neglected.
- 4.
The term “goods” includes all products, factors and securities—everything bought and sold, except money itself.
- 5.
The change in prices, in terms of which the “substitution of goods for money” and the “monetary effect” are defined, is taken as proportional change in all prices except interest rates, because on this basis all intra-temporal and intertemporal substitution is excluded (and index number problems avoided).
- 6.
In the case of an excess demand for goods, where a proportional rise in prices is postulated, the corresponding conditions are that the real excess supply of cash balances should be reduced, increased or unchanged. A positive monetary effect requires that: goods be substituted for money when prices fall, and money for goods when prices rise; or—algebraically, as Lange usually puts it—that the real excess demand for cash balances be reduced when prices fall and increased when prices rise.
- 7.
In fairness to Lange, it should be mentioned that the sequence of argument in Prices Flexibility and Employment is very different from that here given. For instance, Lange does not introduce the concept of inter-temporal substitution until Chapter V, and works out his basic analysis on the assumption of “static” price expectations (a special case of expectations of unit elasticity). However, I have done my best, in the brief space available, to avoid distorting the essentials of his theoretical position. It should also be mentioned that in Lange’s analysis, and in the re-statement of it here, assumptions of a “closed economy” and “perfect competition” are made provisionally, to be removed in due course.
- 8.
For simplicity, the argument will run chiefly in terms of excess supplies (of products or factors), leading to falling prices; but all propositions will apply, mutatis mutandis, to excess demands and rising prices.
- 9.
Unless a full “sequence analysis” is resorted to—necessitating an elaborate series of “models” to deal with more than the simplest eases—this “theoretical experiment” technique seems to be the only means of testing “stability conditions”. It is, however, a very tricky technique—cf., for example, the illuminating analysis made by Kaldor of Pigou’s conduct of such an “experiment” in this field (Economic Journal, September, 1937, pp. 405; December, 1937, pp. 745; and March, 1938, pp. 134).
- 10.
If the price expectations which directly influence the product or factor originally in excess supply are highly inelastic, the original excess supply may disappear or be greatly reduced as a result of inter-temporal substitution, even in the absence of a monetary effect; but excess supply will then appear elsewhere in the economy. Lange seems to suggest (e.g., p. 27) that the elasticity of the price expectations directly influencing the product or factor in excess supply may have expectations directly influencing the product or factor in excess supply may have a net effect on the aggregate excess supply in the economy (additive to the monetary effect) but this is clearly inconsistent with his own definition of the monetary effect.
- 11.
Negative price flexibility would in this case tend to restore equilibrium.
- 12.
“The excess demand for cash balances”, defined in this way, corresponds exactly with the (n+1)th equation which must be eliminated from the determining conditions of equilibrium, because, as Hicks says, it “follows from the rest”, and stands merely for the balancing of accounts (Value and Capital, Chapters IV and XII).
- 13.
Excess demand for “money income” is not altogether a precise term for this part of the “excess demand for cash balances”. But especially in view of the practical importance of factor unemployment it is perhaps succinctly descriptive. That Lange’s “excess demand for cash balances” does not correspond with the Keynesian concept of “excess demand for liquidity” is well evidenced by the fact that, according to Lange, the existence of an “excess demand for cash balance” is quite consistent with constancy of the rate of interest and equilibrium in the bond market (p. 16).
- 14.
The effects are reversed when current prices rise.
- 15.
General Theory, Chapters 13 and 16.
- 16.
It should be remembered that, in Lange’s hypothetical situation in which all prices (except interest rates) have changed in the same proportion, all outputs are unchanged and the value of transactions being carried on is proportional to prices.
- 17.
No reference has been made above to the “finance” motive for liquidity preference, which Keynes introduced in the course of the famous Economic Journal controversy. If prices fall and expectations are inelastic, the “shift of planned controversy”; If prices fall and expectation are inelastic, the “shift of planned purchases from the future to the present” (which in Lange’s terminology reduces for liquidity to “finance” the impending purchases). It is also possible that changes in current prices, and in the relationship between current and expected future in current prices, and in the relationship between current and expected future in the demand schedule for “idle balances”.
- 18.
That the General Rule is valid in this special case no doubt accounts for Lange’s surprising neglect of factors which he himself brilliantly analysed in his celebrated article (The Rate of Interest and the Optimum Propensity to Consume) in Economica, February 1938. For the General Rule is put forward in Chapter V and in Chapter VI (p. 29) it is stated that in the preceding chapters it has been assumed that future prices (including bond prices), are expected with (subjective) certainty. In this case, there being no uncertainty as to future interest rates, there are no idle balances and the General Rule is valid; but when Lange relaxes the “certainty” assumption in Chapter VI, he omits to re-state (or scrap) the General Rule, and continues to apply it through the rest of the book.
However, this point reveals a further inconsistency in Lange’s analysis. For if there is no uncertainty about future interest rates, then as Keynes has pointed out (General Theory, p. 171), the slightest “excess supply” of liquidity will cause an immediate fall in interest rates in whatever degree is necessary to raise employment and income sufficiently to absorb the whole existing quantity of money in “transactions balances”. In other words, unless the quantity of money is rapidly and continuously reduced, flexible prices will in these circumstances guarantee a positive monetary effect and automatic maintenance of full employment, with prices proportional to the quantity of money if the demand for “transactions balances is proportional to income”. Hence in Chapters I to V of Lange’s analysis, in strict conformity with his assumptions, should have been confined to “the Quantity Theory of Money in its traditional form” (as set out by Keynes in pp. 208‒209 of the General Theory).
- 19.
The principal references are: Wicksell, Lectures on Political Economy, Interest and Prices; Keynes, The General Theory of Employment, Interest and Money: Hicks, Value and Capital (especially Chapters XX to XXII); Pigou, Employment and Equilibrium, and Economic Journal (September 1937; March 1938; June–September 1942 and December 1943); Kaldor, Economic Journal (December 1938; December 1941 and June–September, 1942).
- 20.
The assumption that price expectations are of unit elasticity in effect reduces the problem to “static” terms, since current and expected prices move proportionally. This is pointed out by Hicks on p. 206 of Value and Capital, but on p. 273 he says instead that there is “an exact correspondence between the static system and the temporary equilibrium system” only “in the case where all expectations are rigidly inelastic”. This slip vitiates much of his analysis in Chapter XXII (which begins on p. 273). For example, on p. 276 he explains very ingeniously, in terms of inelastic expectations, an apparently paradoxical conclusion derived from the rules of the static system, which could have been much more simply (and accurately) explained in terms of expectations of unit elasticity, merely by reference back to p. 108. Wicksell and Pigou both explicitly assume price expectations of unit elasticity.
- 21.
Cf. Leontief, Quarterly Journal of Economics, November 1936; Lange, 10n.
- 22.
Lectures, Vol. II. pp. 196‒197: “Thus the great and decisive difference between relative commodity prices on the one hand and the general price-level on the other in… that the equilibrium of the former is usually stable and is to be likened to a freely suspended pendulum, or a ball at the bottom of a bowl. If by accident they are driven out of the position of equilibrium, they tend themselves, i.e. through the force of gravity, to resume their former position. The general price-level on the other hand is, on the assumption of a monetary system of unlimited elasticity, in a position of, so to speak, indifferent equilibrium of the same kind as that of a ball position of, so to speak, indifferent equilibrium of the same kind as that of a ball or cylinder on a plane … surface”. What Wicksell apparently did not recognize (except in the special case of a discrepancy between the normal and loan rates of interest) is that the forces making for the restoration of equilibrium relative prices would, “on the assumption of a monetary system of unlimited elasticity”, entirely spend themselves in shifting money prices (as represented by the ball or cylinder on the plane surface) and never obtain a sufficiently firm foothold to shift relative prices.
- 23.
This proposition, as stated by Kaldor in criticism of a contrary argument by Pigou, was accepted by Pigou “under a logical rod wielded privately by Mr. Champernowne” (Economic Journal, September and December, 1937, March, 1938). In Employment and Equilibrium, p. 196, Pigou agrees that, on the assumption that banking policy maintains constant interest rates, “those writers who affirm that differences in money wage rates are associated with equi-proportionate differences in money incomes and money prices, leaving employment unvaried, are right”. But in the Economic Journal December 1943, Pigou regains his original position by introducing n new factor, not present in the models previously discussed—namely, the dependence of the level of saving on the real value of the stock of money (see under (6) in the text below).
- 24.
General Theory, p. 191.
- 25.
Pigou: Economic Journal, Dec. 1943, p. 349. Haberler: Prosperity and Depression, Third Edition, p. 498.
- 26.
Economic Journal, April, 1944, p. 181.
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Swan, P.L. (2022). T. W. Swan: “Price Flexibility and Employment”. In: Trevor Winchester Swan, Volume I. Palgrave Studies in the History of Economic Thought. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-031-13737-2_9
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