Toward the rebuilding of modern macroeconomic theory: Market failure and Keynes' unemployment

Eizo Kawai

No e186, Working Papers from Tokyo Center for Economic Research

Abstract: This study perceives an unacceptable unreality of a macro price mechanism: i.e., the unreality that under any severe recession, worsening deflation, or a consistent decline in the rate of inflation will lead an economy to full employment equilibrium. This unreality is a result of an arbitrary assumption that the micro price mechanism operates even in a macroeconomy: a fallacy of composition. This study challenges the modern macroeconomics theories on price mechanism and unemployment based on the skepticism toward existing theories. This study gets the following two conclusions: First, in a macroeconomy, market failure occurs because the price mechanism does not function, especially under deflation. Consequently, even if nominal values are sufficiently flexible, steady-state and thus full employment equilibrium do not hold. In other words, there is no macro general equilibrium corresponding to a micro general equilibrium. Market failure in a short-run macroeconomy is because of the unavoidable spillover effects, or the derived demand effects between goods and labor markets under disequilibrium from rigid wages and prices. Market failure would occur even in the long-term macroeconomy as an inevitable conjecture from the short-run analysis. For the above analyses, a static model is sufficient, and dynamic models are unnecessary and theoretically unfeasible. Second, Keynes' unemployment equilibrium is realized owing to market failure in a macroeconomy. It shows that involuntary unemployment results from quantitative and not price aspects. In other words, the unemployment results from shortage in labor demand under rigid real wages and not under rigidity of real wages. Final section shows three novel proposals for future contributions of this study's implications.

Pages: 43 pages
Date: 2023-07
New Economics Papers: this item is included in nep-inv and nep-mac
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