Keynes and The General Theory Intermediate Macroeconomics ECON-305 Spring 2013 Professor Dalton Boise State University

The Keynesian Challenge Capitalists economies are not self-adjusting and therefore active government intervention is necessary to guide the economy.

The Keynesian Challenge Theoretical Contribution Theoretical Contribution Why aren’t capitalist economies self-adjusting? Policy Contribution Policy Contribution What should government do to guide the economy?

Keynes’ Background Applied “Marshallian” economist Applied “Marshallian” economist Writer of tracts, not treatises Writer of tracts, not treatises Polemicist of the first-order Polemicist of the first-order “Presuppositions of Harvey Road” “Presuppositions of Harvey Road”

Evaluations of The General Theory Fundamentally mistaken Fundamentally mistaken Carelessly written Carelessly written Poorly organized Poorly organized Inconsistent Inconsistent Work of genius Work of genius Fertile Fertile Fundamentally correct Fundamentally correct

There is no definitive interpretation of “Keynesian economics.”

Focus What determines the level of national income and the amount of employment?

Principle of Effective Demand In a closed economy with spare capacity, the level of output and hence employment is determined by aggregate planned expenditures.

The Basic Keynesian “Model”

Principle of Effective Demand E = C + I E = C + I C = f(Y) C = f(Y) I = g(∏ e, r) I = g(∏ e, r) Consumption – passive (∆Y) Consumption – passive (∆Y) Investment – volatile (∆∏ e ) Investment – volatile (∆∏ e ) Therefore, Y and L are volatile Therefore, Y and L are volatile

Principle of Effective Demand C = cY C = cY Where 0 < c < 1; the “fundmental psychological law” Where 0 < c < 1; the “fundmental psychological law” E = cY + I, and in equilibrium, E = Y E = cY + I, and in equilibrium, E = Y Y = cY + I Y = cY + I Y – cY = I or (1-c)Y = I Y – cY = I or (1-c)Y = I Y = I/(1-c) and thus ∆Y = ∆I/(1-c) Y = I/(1-c) and thus ∆Y = ∆I/(1-c) Income and output change by a multiple of changes in investment Income and output change by a multiple of changes in investment

Interest rate determination Interest is a purely monetary phenomenon Interest is a purely monetary phenomenon Interest is the reward for parting with “liquidity” Interest is the reward for parting with “liquidity” Liquidity is desirable because of uncertainty Liquidity is desirable because of uncertainty ∆uncertainty ∆Md ∆r ∆uncertainty ∆Md ∆r ∆r ∆I ; therefore money is non- neutral ∆r ∆I ; therefore money is non- neutral

Keynes’ Vision

Main Elements of Keynes’ Vision Demand-side vision Demand-side vision Output and income (Y) is generally not at the full employment output level (Y F ) Output and income (Y) is generally not at the full employment output level (Y F ) Both monetary and fiscal policy are potential means to alter outcomes Both monetary and fiscal policy are potential means to alter outcomes Government and the “socialization of investment” Government and the “socialization of investment” The Fundamental Fact? The Fundamental Fact? Uncertainty

Keynes versus “Classical” Economics

Keynes’ Critiques Theory of output and employment Theory of output and employment Say’s Law Say’s Law Quantity Theory of Money Quantity Theory of Money

Keynes on Labor Markets Labor market does not clear and involuntary unemployment is the result. Labor market does not clear and involuntary unemployment is the result. Two arguments: Two arguments: (1) rigidity of money wages (1) rigidity of money wages (2) flexible money wages are not powerful enough to restore full employment (2) flexible money wages are not powerful enough to restore full employment

P YW/P L DLDL SLSL Y = A F(K,L) L0L0 Y 0 = Y F AS 0 w0w0 AD 1 P1P1 W1W1 Begin at full employment; Y 0 = Y F. Suppose AD falls – Prices fall from P 0 to P 1. With nominal wages fixed at W 1, the real wage rises to w 1. The QD of labor at w 1 is L 1. Involuntary unemployment of L S – L 1 exists. At w 1, employment of L 1 yields an output of Y 1 … Output is below full employment. AD 0 w1w1 ES P0P0 L1L1 LSLS Y1Y1

Rigid Wages Equilibrium can seemingly be restored if either W falls or P rises (both reduce real wage w) Equilibrium can seemingly be restored if either W falls or P rises (both reduce real wage w) Doubts that W are flexible. Doubts that W are flexible. Doubts that falling W can restore equilibrium. Doubts that falling W can restore equilibrium. Increases in AD raise P and restore equilibrium. Increases in AD raise P and restore equilibrium.

Rigid Wages Keynes argued reducing W should be rejected Keynes argued reducing W should be rejected Wasteful struggle Wasteful struggle Workers desire relative wage stability, not real wages Workers desire relative wage stability, not real wages Workers can not collectively reduce money wages and maintain relative wages Workers can not collectively reduce money wages and maintain relative wages flexible monetary policy preferable flexible monetary policy preferable Workers won’t resist real wage reductions because relative wages remain intact Workers won’t resist real wage reductions because relative wages remain intact

P YW/P L DLDL SLSL Y = A F(K,L) L0L0 Y 0 = Y F AS 0 w0w0 AD 1 P1P1 W1W1 Begin at Y 1 If W falls to W 0 it would appear that full employment would be restored because real wages fall. The fall in the real wage reduces the short run AS curve and equilibrium is restored through a further fall in P to P 2. Real wages adjust downward to w 0 and employment and output expand back to L 0 and Y 0, respectively. As P falls, why does output expand back to Y 0 ? AD 0 w1w1 ES P0P0 L1L1 LSLS Y1Y1 W0W0 P2P2

Flexible Wages Keynes argues that a fall in W that causes P to fall operates through the money market. Keynes argues that a fall in W that causes P to fall operates through the money market. A fall in P increases the real money supply and reduces r, which spurs investment spending I, thereby increasing Y. A fall in P increases the real money supply and reduces r, which spurs investment spending I, thereby increasing Y. “Keynes Effect” “Keynes Effect”

Failure of Flexible Wages Two reasons why “Keynes Effect” will fail Two reasons why “Keynes Effect” will fail (1) Liquidity trap People prefer to add additional real money supply to cash balances rather than spend or invest (2) Interest-inelastic investment (2) Interest-inelastic investment Additional investment is small relative to interest rate changes

Failure of Flexible Wages But if falling wages don’t restore equilibrium through the “Keynes Effect,” neither can monetary policy But if falling wages don’t restore equilibrium through the “Keynes Effect,” neither can monetary policy Government must increase AD directly Government must increase AD directly

Keynes on Say’s Law Keynes viewed Say’s Law as equivalent to saying that people never changed their desired cash balances Keynes viewed Say’s Law as equivalent to saying that people never changed their desired cash balances Keynes denied that interest rates affect consumption or saving decisions and denied they are determined in loanable funds market Keynes denied that interest rates affect consumption or saving decisions and denied they are determined in loanable funds market

Keynes on Say’s Law Keynes argued that saving was “not spending” Keynes argued that saving was “not spending” Interest rates determine the form, not the quantity of saving Interest rates determine the form, not the quantity of saving Instead of r insuring that S = I, Keynes argued saving adjusts to investment through changes in Y Instead of r insuring that S = I, Keynes argued saving adjusts to investment through changes in Y

Keynes on Quantity Theory Denied monetary neutrality. Denied monetary neutrality. Asserted QTM required “Full employment” or vertical AS; when Y < Y F, changes in AD cause both Y and P to change. Asserted QTM required “Full employment” or vertical AS; when Y < Y F, changes in AD cause both Y and P to change. For Keynes, the effect of increasing AD is indirect – through r and I, rather than directly through C. For Keynes, the effect of increasing AD is indirect – through r and I, rather than directly through C.

Keynes on Quantity Theory Speculative motive in liquidity preference means demand for money and therefore V not constant. Speculative motive in liquidity preference means demand for money and therefore V not constant. Because both V and Y vary, Because both V and Y vary, ∆M ∆P; ∆M can also ∆V and ∆Y

Three Interpretations “Hydraulic” Keynesianism “Hydraulic” Keynesianism “Fundamentalist” Keynesianism “Fundamentalist” Keynesianism “Modified General Equilibrium Approach” “Modified General Equilibrium Approach”

Three Interpretations “Hydraulic” Keynesianism “Hydraulic” Keynesianism Focuses on W, P and r rigidities Focuses on W, P and r rigidities IS/LM model of Hicks, Modigliani, and Samuelson IS/LM model of Hicks, Modigliani, and Samuelson “Orthodox Keynesianism” “Orthodox Keynesianism” Neo-Classical Synthesis Neo-Classical Synthesis Weakness: why rigidities? Weakness: why rigidities? New Keynesians supply answer New Keynesians supply answer

Three Interpretations “Fundamentalist” Keynesianism “Fundamentalist” Keynesianism Focuses on uncertainty and income effects Focuses on uncertainty and income effects Rejects the Principle of Gross Substitution Rejects the Principle of Gross Substitution Shackle, Robinson, Davidson Shackle, Robinson, Davidson Post Keynesian economics Post Keynesian economics

Three Interpretations “General Disequilibrium” Keynesianism “General Disequilibrium” Keynesianism Coordination failures – cumulative output declines are result of wrong price signals in a world of incomplete knowledge and quantity adjustments being favored over price adjustments Coordination failures – cumulative output declines are result of wrong price signals in a world of incomplete knowledge and quantity adjustments being favored over price adjustments None of orthodox Keynesian building blocks (liquidity trap, wage rigidity, interest-inelastic investment) are crucial to Keynes’ economics None of orthodox Keynesian building blocks (liquidity trap, wage rigidity, interest-inelastic investment) are crucial to Keynes’ economics

“New Keynes” Scholarship Focuses on early Keynes Focuses on early Keynes Methodology and Philosophy Methodology and Philosophy Treatise on Probability (1921) Treatise on Probability (1921) Uncertainty, knowledge, ignorance and probability Uncertainty, knowledge, ignorance and probability Given support to both Fundamentalist and General Disequilibrium approaches to understanding Keynes Given support to both Fundamentalist and General Disequilibrium approaches to understanding Keynes