Price-Quantity Adjustment in a Keynesian Economy

Abstract

In this paper a price and quantity adjustment process in continuous time is considered for an economy with production factors and final goods. We assume that each final good is produced by a constant returns to scale production technology with only factor goods as inputs. The price and quantity adjustments take place on the markets for factor goods only. During the process, the prices in the final good markets adjust instantaneously by setting the price of a final good equal to the production costs. Production adjusts instantaneously to meet the demand and keeping the output markets in equilibrium. The adjustment process consists of three consecutive parts. First, in the short run part of the process the factor prices are assumed to be rigid and only quantity adjustments take place until an out of equilibrium situation is reached in which on each market either equilibrium under supply rationing prevails or excess demand and no supply rationing is observed. Next, in the mid run the factor prices are adjusted upwards in markets with excess demand, while on the other factor markets the supply rationing is adjusted to keep them in equilibrium. This process of adjusting quantity constraints in factor markets with excess supply and prices on factor markets with excess demands is shown to lead to a supply constrained equilibrium. Thirdly, in the long run the factor prices in markets with supply constraints are decreased, whereas supply constraints and prices in all other factor markets adjust to keep those markets in equilibrium. It is shown that eventually a Walrasian price system is reached.