An Important Inconsistency at the Heart of the Standard Macroeconomic Model

The standard neoclassical model is the foundation of most mainstream macroeconomics. Its basic structure
dominates the analyis of macroeconomic phenomena, the teaching of the subject, and even the formation of
economic policy. And, of course, the modern quantity theory of money and its attendant monetarist
prescriptions are grounded in the model’s strict separation between real and nominal variables.
It is quite curious, therefore, to discover that this model contains an inconsistency in its treatment of the
distribution of income. And when this seemingly small discrepancy is corrected, without any change in all of
the other assumptions, many of the model’s characteristic results disappear.

Two instances are of particular
interest. First, the strict dichotomy between real variables and nominal variables breaks down, so that, for
example, an increase in the exogenously given money supply changes real variables such as household income,
consumption, investment, the interest rate, and hence real money demand. Secondly, since the price level
depends on the interaction of real money demand and the nominal money supply, and since the former is now
affected by the latter, price changes are no longer proportional to changes in the money supply. Indeed, we will
demonstrate that prices can even fall when the money supply rises. The link to the quantity theory of money,
and to monetarism, is severed.