KeynesKeynesand and The The

General TheoryGeneral TheoryIntermediate MacroeconomicsIntermediate Macroeconomics

ECON-305 Spring 2013ECON-305 Spring 2013Professor DaltonProfessor Dalton

Boise State UniversityBoise State University

The Keynesian ChallengeThe Keynesian Challenge

Capitalists economies are Capitalists economies are not self-adjusting and not self-adjusting and

therefore active therefore active government intervention is government intervention is

necessary to guide the necessary to guide the economy.economy.

The Keynesian ChallengeThe Keynesian Challenge Theoretical ContributionTheoretical Contribution

Why aren’t capitalist economies Why aren’t capitalist economies self-adjusting?self-adjusting?

Policy ContributionPolicy Contribution

What should government do to What should government do to guide the economy?guide the economy?

Keynes’ BackgroundKeynes’ Background

Applied “Marshallian” economistApplied “Marshallian” economist Writer of tracts, not treatisesWriter of tracts, not treatises Polemicist of the first-orderPolemicist of the first-order ““Presuppositions of Harvey Presuppositions of Harvey

Road”Road”

Evaluations ofEvaluations ofTheThe General TheoryGeneral Theory

Fundamentally mistakenFundamentally mistaken Carelessly writtenCarelessly written Poorly organizedPoorly organized InconsistentInconsistent Work of geniusWork of genius FertileFertile Fundamentally correctFundamentally correct

There is no There is no definitive definitive

interpretation of interpretation of “Keynesian “Keynesian economics.”economics.”

FocusFocus

What determines What determines the level of national the level of national

income and the income and the amount of amount of

employment?employment?

Principle of Effective Principle of Effective DemandDemand

In a closed economy with In a closed economy with spare capacity, the level of spare capacity, the level of

output and hence output and hence employment is determined employment is determined

by aggregate planned by aggregate planned expenditures.expenditures.

The Basic The Basic Keynesian Keynesian “Model”“Model”

Principle of Effective Principle of Effective DemandDemand

E = C + IE = C + I C = f(Y)C = f(Y) I = g(∏I = g(∏ee, r), r) Consumption – passive (∆Y)Consumption – passive (∆Y) Investment – volatile (∆∏Investment – volatile (∆∏ee)) Therefore, Y and L are volatileTherefore, Y and L are volatile

Principle of Effective Principle of Effective DemandDemand

C = cYC = cY Where 0 < c < 1; the “fundmental Where 0 < c < 1; the “fundmental

psychological law”psychological law” E = cY + I, and in equilibrium, E = YE = cY + I, and in equilibrium, E = Y Y = cY + IY = cY + I Y – cY = I or (1-c)Y = IY – 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 Income and output change by a

multiple of changes in investmentmultiple of changes in investment

Interest rate Interest rate determinationdetermination

Interest is a purely monetary Interest is a purely monetary phenomenonphenomenon

Interest is the reward for parting with Interest is the reward for parting with “liquidity”“liquidity”

Liquidity is desirable because of Liquidity is desirable because of uncertaintyuncertainty

∆∆uncertainty ∆Md ∆runcertainty ∆Md ∆r ∆∆r ∆I ; therefore money is non-r ∆I ; therefore money is non-

neutralneutral

Keynes’ VisionKeynes’ Vision

Main Elements of Main Elements of Keynes’ VisionKeynes’ Vision

Demand-side visionDemand-side vision Output and income (Y) is generally not at Output and income (Y) is generally not at

the full employment output level (Ythe full employment output level (YFF)) Both monetary and fiscal policy are potential Both monetary and fiscal policy are potential

means to alter outcomesmeans to alter outcomes Government and the “socialization of Government and the “socialization of

investment”investment” The Fundamental Fact?The Fundamental Fact?

Uncertainty

Keynes versus Keynes versus “Classical” “Classical” EconomicsEconomics

Keynes’ Keynes’ CritiquesCritiques

Theory of output and Theory of output and employmentemployment

Say’s LawSay’s LawQuantity Theory of Quantity Theory of MoneyMoney

Keynes on Labor MarketsKeynes on Labor Markets

Labor market does not clear and Labor market does not clear and involuntary unemployment is the involuntary unemployment is the result.result.

Two arguments:Two arguments:

(1) rigidity of money wages(1) rigidity of money wages

(2) flexible money wages are not (2) flexible money wages are not powerful enough to restore full powerful enough to restore full employment employment

P

YW/P

L

DL

SL

Y = A F(K,L)

L0

Y0 = YF

AS0

w0

AD1

P1

W1

Begin at full employment; Y0 = YF.

Suppose AD falls – Prices fall from P0 to P1.

With nominal wages fixed at W1, the real wage rises to w1.The QD of labor at w1 is L1.

Involuntary unemployment of LS – L1 exists.

At w1, employment of L1 yields an output of Y1…

Output is below full employment.

AD0

w1

ES

P0

L1

LS

Y1

Rigid WagesRigid Wages Equilibrium can seemingly be Equilibrium can seemingly be

restored if either W falls or P rises restored if either W falls or P rises (both reduce real wage w)(both reduce real wage w)

Doubts that W are flexible.Doubts that W are flexible. Doubts that falling W can restore Doubts that falling W can restore

equilibrium.equilibrium. Increases in AD raise P and restore Increases in AD raise P and restore

equilibrium. equilibrium.

Rigid WagesRigid Wages Keynes argued reducing W should be Keynes argued reducing W should be

rejectedrejected Wasteful struggleWasteful struggle Workers desire relative wage stability, not Workers desire relative wage stability, not

real wagesreal wages Workers can not collectively reduce money Workers can not collectively reduce money

wages and maintain relative wageswages and maintain relative wages flexible monetary policy preferableflexible monetary policy preferable

Workers won’t resist real wage reductions Workers won’t resist real wage reductions because relative wages remain intactbecause relative wages remain intact

P

YW/P

L

DL

SL

Y = A F(K,L)

L0

Y0 = YF

AS0

w0

AD1

P1

W1

Begin at Y1

If W falls to W0 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 P2.

Real wages adjust downward to w0 and employment and output expand back to L0 and Y0, respectively.

As P falls, why does output expand back to Y0?

AD0

w1

ES

P0

L1

LS

Y1

W0

P2

Flexible WagesFlexible Wages Keynes argues that a fall in W that Keynes argues that a fall in W that

causes P to fall operates through the causes P to fall operates through the money market.money market.

A fall in P increases the real money A fall in P increases the real money supply and reduces r, which spurs supply and reduces r, which spurs investment spending I, thereby investment spending I, thereby increasing Y.increasing Y.

““Keynes Effect”Keynes Effect”

Failure of Flexible WagesFailure of Flexible Wages Two reasons why “Keynes Effect” will Two reasons why “Keynes Effect” will

failfail

(1) Liquidity trap(1) Liquidity trapPeople prefer to add additional real money People prefer to add additional real money supply to cash balances rather than spend supply to cash balances rather than spend

or or investinvest

(2) Interest-inelastic investment(2) Interest-inelastic investmentAdditional investment is small relative to Additional investment is small relative to

interest rate changesinterest rate changes

Failure of Flexible WagesFailure of Flexible Wages But if falling wages don’t restore But if falling wages don’t restore

equilibrium through the “Keynes equilibrium through the “Keynes Effect,” Effect,” neither can monetary policyneither can monetary policy

Government must increase AD Government must increase AD directlydirectly

Keynes on Say’s LawKeynes on Say’s Law Keynes viewed Say’s Law as Keynes viewed Say’s Law as

equivalent to saying that people equivalent to saying that people never changed their desired cash never changed their desired cash balancesbalances

Keynes denied that interest rates Keynes denied that interest rates affect consumption or saving affect consumption or saving decisionsdecisions and denied they are and denied they are determined in loanable funds marketdetermined in loanable funds market

Keynes on Say’s LawKeynes on Say’s Law Keynes argued that saving was “not Keynes argued that saving was “not

spending”spending” Interest rates determine the form, Interest rates determine the form,

not the quantity of savingnot the quantity of saving Instead of r insuring that S = I, Instead of r insuring that S = I,

Keynes argued saving adjusts to Keynes argued saving adjusts to investment through changes in Yinvestment through changes in Y

Keynes on Quantity Keynes on Quantity TheoryTheory

Denied monetary neutrality.Denied monetary neutrality. Asserted QTM required “Full Asserted QTM required “Full

employment” or vertical AS; when Y < employment” or vertical AS; when Y < YYFF, changes in AD cause both Y and P , changes in AD cause both Y and P to change.to change.

For Keynes, the effect of increasing For Keynes, the effect of increasing AD is indirect – through r and I, rather AD is indirect – through r and I, rather than directly through C.than directly through C.

Keynes on Quantity Keynes on Quantity TheoryTheory

Speculative motive in liquidity Speculative motive in liquidity preference means demand for money preference means demand for money and therefore V not constant.and therefore V not constant.

Because both V and Y vary,Because both V and Y vary,

∆∆M ∆P; ∆M can also ∆V and ∆YM ∆P; ∆M can also ∆V and ∆Y

Three InterpretationsThree Interpretations

““Hydraulic” KeynesianismHydraulic” Keynesianism““Fundamentalist” Fundamentalist”

KeynesianismKeynesianism““Modified General Modified General

Equilibrium Approach”Equilibrium Approach”

Three InterpretationsThree Interpretations

““Hydraulic” KeynesianismHydraulic” Keynesianism Focuses on W, P and r rigiditiesFocuses on W, P and r rigidities IS/LM model of Hicks, Modigliani, and IS/LM model of Hicks, Modigliani, and

SamuelsonSamuelson ““Orthodox Keynesianism”Orthodox Keynesianism”

Neo-Classical SynthesisNeo-Classical Synthesis Weakness: why rigidities?Weakness: why rigidities? New Keynesians supply answerNew Keynesians supply answer

Three InterpretationsThree Interpretations

““Fundamentalist” KeynesianismFundamentalist” Keynesianism Focuses on uncertainty and income Focuses on uncertainty and income

effectseffects Rejects the Principle of Gross Rejects the Principle of Gross

SubstitutionSubstitution Shackle, Robinson, DavidsonShackle, Robinson, Davidson Post Keynesian economicsPost Keynesian economics

Three InterpretationsThree Interpretations

““General Disequilibrium” KeynesianismGeneral Disequilibrium” Keynesianism Coordination failures – cumulative output Coordination failures – cumulative output

declines are result of wrong price signals declines are result of wrong price signals in a world of incomplete knowledge and in a world of incomplete knowledge and quantity adjustments being favored over quantity adjustments being favored over price adjustmentsprice adjustments

None of orthodox Keynesian building None of orthodox Keynesian building blocks (liquidity trap, wage rigidity, blocks (liquidity trap, wage rigidity, interest-inelastic investment) are crucial interest-inelastic investment) are crucial to Keynes’ economicsto Keynes’ economics

““New Keynes” New Keynes” ScholarshipScholarship

Focuses on early KeynesFocuses on early Keynes Methodology and PhilosophyMethodology and Philosophy Treatise on Probability Treatise on Probability (1921)(1921)

Uncertainty, knowledge, ignorance and Uncertainty, knowledge, ignorance and probabilityprobability

Given support to both Given support to both FundamentalistFundamentalist and and General Disequilibrium General Disequilibrium approaches approaches to understanding Keynesto understanding Keynes