the orthodox keynesian school.ppt

04/11/2023 mirza asjad baig 1

“THE ORTHODOX KEYNESIAN SCHOOL”

MACROECONOMICS


INTRODUCTION• Keynes’s system did allow for a restoration of full employment

equilibrium via price flexibility. (Modigliani’s ,1944).

• it was generally accepted that neoclassical microeconomics and Keynesian macroeconomics could sit alongside each other.(Samuelson ,1955)

• The classical/neoclassical model remained relevant for microeconomic issues and the long-run analysis of growth.

• Orthodox Keynesian macroeconomics provided the most useful framework for analyzing short-run aggregate phenomena.


MAIN PURPOSE• FIRST To review one highly influential orthodox Keynesian interpretation of

Keynes’s (1936) General Theory, namely the Hicksian IS–LM model for a closed economy.

• SECOND To consider the effectiveness of fiscal and monetary policy for

stabilization purposes when the model is extended to an open economy.

• THIRD To discuss the original Phillips curve analysis and comment on the

importance of the Phillips curve to orthodox Keynesian analysis.• FOURTH To summarize the central propositions of orthodox Keynesian economics


ISSUES

• Two recurrent and interrelated issues arise throughout this and subsequent chapters, concerning:

1. The controversy over the self-equilibrating properties of the economy.

2. The role for interventionist government policies.


The Orthodox Keynesian School• The economy is inherently unstable and is subject to erratic shocks.

• the economy can take a long time to return to the neighborhood of full employment after being subjected to some disturbance.

• The aggregate level of output and employment is essentially determined by aggregate demand.

• The effects of fiscal policy measures are considered to be more direct, predictable and faster acting on aggregate demand than those of monetary policy


IS–LM MODEL

A macroeconomic model that graphically represents two intersecting curves, called the IS and LM curves.

• The investment/saving (IS) curve is a variation of the income-expenditure model incorporating market interest rates (demand for this model).

• The liquidity preference/money supply equilibrium (LM) curve represents the amount of money available for investing (supply for this model).

M / P = L(i,Y)


THE SHORT RUN EQUILIBRIUM IN A CLOSED ECONOMY

• The IS curve summarizes all combinations of income and interest rates that clear the market for goods and services.

• The LM curve summarizes all combinations of income and interest rates that clear the money market.


THE SHORT RUN EQUILIBRIUM IN A CLOSED ECONOMY

• Anywhere other than the intersection, which we label i0 and Y0 , we would expect there to be changes in Y or i that restore either goods market or money market equilibrium.

• Generally, we believe that the money market adjusts very quickly so the economy will rarely be off the LM curve. However, it will not stay off the IS curve for very long either as firms can adjust production to bring it in line with demand.

• Consider a point like A. Even though the money market is in equilibrium, the goods market is not (we are off the IS curve). At that low interest rate, Y is too low to clear the goods market so firms increase production and Y rises. As Y rises, i has to rise as well in order to maintain money market equilibrium so the economy moves towards the intersection point.

• Now consider a point like B. Once again, the money market is in equilibrium but the goods market is not (we are off the IS curve). At that high interest rate, Y is too high to clear the goods market so firms decrease production and Y falls. As Y falls, i has to fall as well in order to maintain money market equilibrium so the economy moves towards the intersection point.


USING THE IS-LM MODEL TO ANALYZE FISCAL POLICY

We can use the IS-LM model to look at the impact of fiscal policy: government decisions on taxation and spending. Economists refer to increases in government purchases or cuts in taxes as expansionary fiscal policy. Cuts in government purchases and increases in taxes are referred to as contractionary fiscal policy.


USING THE IS-LM MODEL TO ANALYZE MONETARY POLICY• We can also use the IS-LM model to think about monetary policy decisions. When

the Fed pursues an expansionary monetary policy, i.e. it increases the money supply, we showed that this would cause the LM curve to shift to the right. From the graph below we see that this causes GDP to rise and interest rates to fall in the economy.

• The opposite would be true for contractionary monetary policy. The decrease in money supply causes interest rates to rise in order to restore money market equilibrium. On the goods market side, the higher interest rates result in decreased investment spending, which in turn lowers Y.


UNDEREMPLOYMENT EQUILIBRIUM IN THE KEYNESIAN MODEL

• Excess supply of labour → W↓ → production costs ↓ → P ↓ →real money (M/P)↑ → excess supply of money, people bidbonds, r↓ and LM shifts to the right (see next slide), at thesame time I↑ → AD↑ → Y↑ → N↑

• Higher AD moderates decrease of price level, so nominal wage falls faster than price (unbalanced deflation) → real wage falls.

• The model converges towards full employment equilibrium,underemployment equilibrium does not exists.


THE GENERAL CASE WITH THE KEYNES EFFECT


UNDEREMPLOYMENT EQUILIBRIUM

• Given the reality of great depression, Keynes was seeking for an explanation of long-lasting underemployment equilibrium.

• In the longer-run, nominal wage could not have been considered as fixed.

• When – with flexible wages - his model converges to full employment equilibrium, he needed additional assumptions to allow for a theoretical possibility of stable underemployment

equilibrium.• He, indeed, claims that two cases arise when underemployment

equilibrium exists:

– Liquidity trap– Interest-inelastic investment function


LIQUIDITY TRAP• When interest so low, that demand for money becomes infinitely

interest elastic (horizontal), then– Absolute liquidity preference (nobody wants to purchase additional

bonds).– Interest does not react to changes in supply of nominal money

liquidity trap.

• LM curve becomes for some low value of interest also horizontal• Never observed in reality, in some situation, some economies

close(Great Depression, Japan in the1990s)


KEYNES EFFECT LOCKED

• When interest very low, only increase expected, i.e. only fall of bond prices expected as well →

• Even when amount of real money increases, people do not bid for bond, but keep additional idle balance as cash →

• Fall of nominal wages and prices (both decrease proportionally – balanced deflation) does not lead to fall of interest, increase of investment, AD, output and employment.

• Economy remains at state of rest with involuntary unemployment


LIQUIDITY TRAP


INTEREST-INELASTIC INVESTMENT FUNCTION

• When investment reacts very slowly to large changes in interest then even a fall to zero level interest does not have to generate aggregate demand strong enough to allow for full employment equilibrium output.

• At least theoretically, the economy can stay at state of rest with zero interest and output with involuntary unemployment.

• Graphically: IS curve very steep, full employment output would require ISLM intersection at negative interest rate.


THE INTEREST-INELASTIC INVESTMENT CASE


THE CENTRAL PROPOSITIONS OF ORTHODOX KEYNESIAN ECONOMICS

First Proposition: Modern industrial capitalist economies are subject to anendemic flaw in that they are prone to costly recessions, sometimes severe,which are primarily caused by a deficiency of aggregate (effective) demand.Recessions should be viewed as undesirable departures from full employmentequilibrium that are generally caused by demand shocks from a variety ofpossible sources, both real and monetary.

Second Proposition: Orthodox Keynesians believe that an economy can be ineither of two regimes. In the Keynesian regime aggregate economic activityis demand-constrained. In the classical regime output is supply constrainedand in this situation supply creates its own demand (Say’s Law).



Third Proposition: Unemployment of labour is a major feature of the Keynesianregime and a major part of that unemployment is involuntary in that it consists of people without work who are prepared to work at wages that employed workers of comparable skills are currently earning (see for example, Solow, 1980; Blinder, 1988).

•Fourth Proposition: ‘A market economy is subject to fluctuations in aggregate output, unemployment and prices, which need to be corrected, can be corrected, and therefore should be corrected’ (Modigliani, 1977, 1986). The discretionary and coordinated use of both fiscal and monetary policy has an important role to play in stabilizing the economy. These macroeconomic instruments should be dedicated to real economic goals such as real output and employment.

Fifth Proposition: In modern industrial economies prices and wages are not perfectly flexible and therefore changes in aggregate demand, anticipated or unanticipated, will have their greatest impact in the short run on real output and employment rather than on nominal variables



Sixth Proposition:Business cycles represent fluctuations in output, which are undesirable deviations below the full employment equilibrium trend path of output. Business cycles are not symmetrical fluctuations around the trend.Seventh Proposition: The policy makers who control fiscal and monetary policy face a non-linear trade-off between inflation and unemployment in the short run.Eighth Proposition: More controversial and less unanimous, some Keynesians,including Tobin, did on occasions support the temporary use of incomespolicies (‘Guideposts’) as an additional policy instrument necessary to obtainthe simultaneous achievement of full employment and price stability (Solow,1966; Tobin, 1977).Ninth Proposition: Keynesian macroeconomics is concerned with the shortrunproblems of instability and does not pretend to apply to the long-run issues of growth and development. The separation of short-run demand fluctuationsfrom long-run supply trends is a key feature of the neoclassical synthesis.


PHILLIPS CURVE• The Phillips curve represents the relationship between the rate of

INFLATION and the UNEMPLOYMENT rate. • Phillips found a consistent inverse relationship: when unemployment

was high, wages increased slowly; when unemployment was low, wages rose rapidly.

http://www.econlib.org/library/Enc/Inflation.html

http://www.econlib.org/library/Enc/Unemployment.html

the orthodox keynesian school.ppt

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