Although acknowledging the possibility of “cost push”, most Neo-Keynesians took up the demand-pull explanation of inflation. F, to the left of the IS-LM-determined equilibrium, Y* and calling the resulting difference the “inflationary gap”. With top applications de rencontre output stuck at YF, excess demand for goods will result in increases in the price level as before. However, unlike the Keynes-Smithies story, there is not a resulting “redistribution” of income to close the gap. Rather, as price level rises, the real money supply collapses and thus the LM curve shifts to the left and thus back to full employment output. Thus, the transmission mechanism implies that any price rises will themselves close the gap by lowering money supply and thus increasing interest rates and thus reducing investment and demand.
However, the Keynes-Smithies facts is advised nearly entirely in the context of earnings and you may expense, meaning that, believe it or not, forgotten brand new monetary front
However, with the LM curve moving to bring the economy to full employment, it seems impossible, in this case, to have sustained price rises (i.e. inflation) as the monetary side seems to close off the story entirely. One could subsequently argue that, as real wages (w/p) declined in the process, then workers would try to bid their money wages back up and thus regenerate the gap. However, recall that from the four-quadrant IS-LM diagram (our earlier Figure 4), when IS-LM centers on the full employment output level so that Y* = YF, then the labor market clears and thus there are apparently no inherent dynamics to imply a rise in wages. If anything, a Pigou Effect arising from the fall in real money balances ought to push the IS curve to the left and actually generate unemployment so the implied dynamic might actually be a fall in money wages (of course, in the process of the original adjustment, IS and LM could move concurrently to the left and land at YF together, but then we are back to a full-employment centered equilibrium). (suite…)