The determinants of nominal income, output and the price level A synthesis of the Keynesian and neo-classical views

This paper deals with one of the oldest problems in macroeconomics: the business cycle (of the old tradition), the fluctuations of output and the price level (of the Keynesian tradition) and the real business cycle (of the recent literature). It examines how demand and supply functions evolve through time after an exogenous shock to demand. It borrows from Keynes the idea that in static equilibrium aggregate demand and aggregate supply functions are essential tools of macroeconomic dynamics. It borrows from Friedman the notion that money plays an essential role in the determination of the macroeconomic equilibrium. The paper derives some empirical implications with regard to the rational behavior of economic agents and shows that, after a change in aggregate demand, real output and the price level will follow a counterclockwise movement in the price-level, real-output plane. This implies that it is incorrect to hypothesize, as has been done by both Keynesians and monetarists alike, that the two variables would be positively correlated. In our model this would only be true if the accelerator principle were to play an important role in the dynamics of aggregate demand.