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Keynesian Economics:
Revolution and
Counterrevolution
• John Maynard Keynes (1883-1946)
– Son of John Neville Keynes author of
Scope and Method of Political
Economy (1891)
– Studied Math at Cambridge, resulted in
Treatise on Probability (1921)
– Attracted into economics by Marshall
– Brief period at the India Office
– Returned to Cambridge at Kings
College
– Worked mainly on monetary policy
– Involved in post WWI peace
conference and critical of the settlement
J. M. Keynes
– The Economic Consequences of the
Peace (1919)
– Tract on Monetary Reform (1923)
– Treatise on Money (1930)
– Break with neoclassical theory
– The General Theory of Employment,
Interest and Money (1936)
– Focus on employment levels and the
possibility of an unemployment
equilibrium
– General Theory—it includes full
employment equilibrium as a special
case
– Keynes a member of the Bloomsbury
Group of artists, writers, and
intellectuals
Keynes’ Critique of the
“Classical” Postulates: I
• The Classical Labour Market
– In classical and neoclassical
economics the demand and supply
of labour determines the real
wage rate
– Cannot be involuntary
unemployment in equilibrium
W/P
S
w
w’
D
D’
n’
n
N
Labour Markets
• The Keynesian Labour Market
– Wage bargaining is about money
wages not real wages
– Wage bargaining cannot
determine the real wage as price
level changes may occur
– Workers react differently to a cut
in real wages caused by price
level increases than to cuts in
money wage rates
– Workers resist money wage cuts
– Importance of relative position,
no union will want to accept wage
cuts in case others do not
Keynesian Labour
Market
Money wages
S
w
D
D’
n’
N
n
Involuntary employment exists because of
downwardly inflexible money wage rates.
ISSUE: Is this assumption critical to the
Keynesian analysis?
Keynes’ Critique of the
Classical Postulates: II
• The Classical theory of the
interest rate, savings and
investment
– The real interest rate is
determined by savings and
investment
– The real interest rate co-ordinates
saving and investment
– What is saved will be spent in the
form of investment expenditure
Classical Interest Rate
Theory
Real i rate
S
S’
i
i’
I
S&I
If the desire to save rises, interest rates fall
and investment increases.
Keynesian Theory of
Interest, Savings and
Investment
• The interest rate is a monetary
phenomenon determined in the
money market
• Savings primarily a function of
income and not very responsive to
the interest rate
• Investment determined by the
interest rate but, more importantly,
by the state of business expectations
• The amount people wish to save at
full employment levels of income
may not equal the level of
investment planned by businesses
Keynesian Theory of
Interest, Savings and
Investment
Money i rate
S at FE
i
I’
I
i is determined in the money market
Both S and I are interest inelastic
I can shift in due to adverse expectations so
That at i FE levels of S > I
Keynesian Critique of
Classical Postulates: III
• Classical Theory of the Demand
for Money
– Demand for money for
transactions purposes
– M = PTk
• Keynesian Theory of the
Demand For Money
– Demand for money for
transactions and as an asset
– At certain times people may
rather hold their assets as money
than as stocks or bonds
Keynes and Say’s Law
• Keynes’ critique of the classical
savings/investment theory and the
classical demand for money theory
constitute a rejection of Say’s law
• At full employment all income is not
necessarily spent as desired saving
may exceed desired investment or
people may wish to increase their
money holdings
• If this happens there is
underconsumption in the sense that
FE Agg S > Agg D
• QUESTION: are there adjustment
processes that will lead back to FE?
The Keynesian Model
• Short run analysis, organization,
technology and capital stock
taken as given
• Aggregation of Marshallian
concepts
• Aggregate supply and aggregate
supply price
• Agg supply drawn as a function
of employment
• Agg supply price is the amount
of income factors would have to
earn to maintain that level of
employment
Aggregate Supply
Proceeds or income
Z
N
Z function rises at an increasing rate due to
diminishing returns—increasing marginal
supply price
Z function in money terms and so assumes
a given price level
Aggregate Demand
• Aggregate demand or aggregate
demand price
• Agg D drawn as a function of
employment
• As employment rises so does
income and expenditure but
expenditure rises by less than
income
• The equilibrium level of
employment is where Agg D =
Agg S and this may or may not
be full employment
Equilibrium
Employment Level
Income and expenditure
Z
y*
D=C+I
n*
N
To proceed Keynes examines the components
of D (C and I) more closely and as a function
of income rather than of employment
Consumption and
Savings
• Keynes lists numerous factors both
subjective and objective that might
affect the “propensity to consume
out of income”
• Keynes argues that consumption
primarily a function of real income
• Propensity to consume and the
marginal propensity to consume
• The consumption function—
consumption as a function of income
• Keynes thought MPC would tend to
decline with income but usually
drawn as constant
Consumption and
Savings
• APC = C/Y
• MPC = ΔC/ΔY
• C = a + bY where b =MPC
C
450 or C = Y
C = a+ bY
Slope = b
a
y
yFE
Y
Consumption and
Savings
• What is not consumed out of
income is saved
• Y=C+S
• APC + APS = 1
• MPC + MPS = 1
S
S
y
-a
yFE
Y
Consumption and
Savings
• Important to note that Keynes
thought of the consumption
function as very stable
• Changes in consumption and
savings due to movements
along the consumption function
(due to changes in income) not
due to shifts in the consumption
function (which would be
caused by changes in the
propensity to consume out of
income)
Investment Expenditure
• Investment depends on interest
rate and the expected future
earnings from the investment
• These are long term
expectations
• Lack of a rational basis for
expectations of earnings a long
time in the future
• State of expectations has a
conventional basis only and can
change quite quickly
Investment Expenditure
i
Optimistic
Pessimistic
MEI
I
MEI curve is very interest inelastic and is
unstable—tends to shift with state of
expectations
Equilibrium Income
For an equilibrium Agg D = Agg S
Y=C+I
450
Agg D
C + I = Agg D
C
S
C
y*
FE
Y
At y* Agg D = Agg S and S = I
However y* need not be FE
If FE > y* then Aggs > Agg D and S > I
Firms will find inventories accumulating and will
reduce employment and income until S = I
The Multiplier
• R. F. Kahn (1931)
– Changes in autonomous expenditures,
such as investment, will have a
multiplied impact on income
– Initial expenditure change will affect
incomes by that amount
– Income change will then affect the
consumption expenditures of those
affected (by change in income x MPC)
– This will affect other peoples’ incomes
and will alter their expenditures in the
same way
– Ultimate effect will be the change in
autonomous expenditure times the
multiplier where M = 1/(1 – MPC)
Implications of the
Analysis so Far
• Equilibrium is where Agg D = Agg
S
• The consumption function is stable
but the investment function is not
• Investment prone to shifts due to
changes in business expectations
• Shifts in I have multiplied effect on
income
• Economic instability due to real not
monetary factors
• To complete the model need to look
at interest rate determination in the
monetary sector
Money and Interest
Rates
• Savings depend on income but there
is still a choice of how to hold ones
savings
• Desire to hold bonds vs money
• Liquidity preference
– Transactions demand for money
– Precautionary demand for money
– Speculative demand for money
• Speculative demand is an asset
demand
• Will hold money if bond prices
expected to fall and bonds if bond
prices expected to rise
Money and Interest
Rates
• Will expect bond prices to fall if
interest rates are expected to
rise and vice versa
• Different people may have
different expectations but when
interest rates are at very low
levels most people will expect a
rise rather than another fall and
will want to hold money rather
than bonds
Money and Interest
Rates
• Speculative demand for money
and the liquidity trap
i
Ms
i
LP
M
Spec Demand
Trans and Precautionary Demand
The Complete
Keynesian Model
i
i
Ms
i
LP
M
MEI
I
I
C+I
Agg D
C
I
450
y*
Y
Adjustment Processes to
Full Employment?
• If y* is at less than FE does anything
happen to drive the economy back to
FE?
• If wages and prices are inflexible
downwards then nothing happens
• If wages and prices are flexible
downward then the price level will
fall
• This will increase the real money
supply, reduce i rates, increase
investment and increase Agg D and
income
• Keynes Effect
Limitations to the
Keynes Effect
• The Keynes effect will likely
not be powerful enough to move
the economy back to full
employment
• Liquidity trap—increase in real
money supply may simply be
absorbed into speculative
balances
• Interest inelasticity of
investment
• Deflation would cause adverse
shifts in business expectations
Policy Implications
• Prolonged recessions due to
insufficient Agg D
• Low and stable interest rates to
encourage private investment
• “Social control” over investment
expenditures
• “Keynesian” policy after WWII
became use of fiscal policy
(government expenditure and tax
policy) to maintain low levels of
unemployment
• Abba Lerner, Joan Robinson and
others, “Functional Finance” to
maintain very low unemployment
levels
Hicks/Hansen Model
• Problem with Keynesian model
is that is goes sequentially from
interest rate determination to
income determination
• Level of income will also affect
demand for money
• Need simultaneous
determination of equilibrium
levels of i and y
• Aggregated general equilibrium
approach—LM and IS curves
LM and IS Curves
• IS curves shows all the
combinations of i and y that will
give I = S
• As i falls, I rises, so to maintain
I = S income will have to be
higher
• LM curve shows all
combinations of i and y that will
give Md = Ms (for a given Ms)
• As i falls, speculative demand
for money rises, so to maintain
Md = Ms, income will have to
be lower to reduce transactions
demand
LM and IS Curves
• LM and IS curves
i
LM
i
IS
y
Y
Patinkin, Pigou, and the
Real Balance Effect
• Critique of Keynes’ view that there
could be an unemployment
equilibrium
• Based on the idea that with flexible
wages and prices unemployment will
lead to falling prices and an increase
in the value of money balances
• Eventually people will cease trying
to increase their money holdings and
will increase consumption
• Does not rely on interest rate
declines or investment expenditure
Real Balance Effect
i
LM
IS’
IS
y*
Y
FE
Fall price level at y* leads to increase in the
Real value of peoples’ money holdings,
Eventually shifting the IS curve rightwards
Patinkin
• Patinkin’s argument was similar but
explicitly included the labour market
• With y < FE both wages and prices
fall
• As they fall in proportion, real wages
remain unchanged and involuntary
unemployment exists (does not deny
the reality of involuntary
unemployment even with flexible
money wages)
• Wage and price declines will
eventually shift IS curve rightward
via real balance effect
• But long run and slow process
Post War
Keynesian/Neoclassical
Synthesis
• Exemplified by Paul Samuelson
• Neoclassical microeconomics
• Keynesian macroeconomics
treated as a short run model
relying on inflexible wages and
prices
• Keynesian model a special case
but the relevant special case for
policy purposes
Inflation and the Phillips
Curve
• The standard Keynesian models
did not incorporate the price
level
• Low unemployment policy
began to cause inflation
• A. W. Phillips (1958) empirical
study on the relationship
between unemployment and %
change in wage rates
• Phillips curve led to notion of
an unemployment/inflation
trade off
Phillips Curve
Rate of change in wages
0
5%
unemployment
Idea of “buying” lower unemployment
With higher rate of inflation
Phillips Curves and
Expectations
• Difficulty with the trade off idea is
that inflation seemed to get worse
• Notion of inflationary expectations
being built into the next round of
wage bargains
• Keeping unemployment below the
“natural rate” (consistent with zero
inflation) results in the long run in
accelerating inflation
• Long run Phillips curve is vertical at
the natural rate
• Rational expectations
The Policy Debate
• Keynesians who favored low
unemployment targets argued
for further government
intervention in the form of wage
and price controls
• Many countries experimented
with wage and price guideposts
or controls in the 1960s and 70s
• The policy alternative came
from the Monetarists
• Milton Friedman and Chicago
Friedman and
Monetarism
• Friedman’s critique of
Keynesian economics had
several dimensions
• Consumption expenditure
responds to changes in
permanent income not
temporary changes in income
• Monetary factors have greater
significance than Keynes or the
Keynesians allowed
• Studies in the Quantity Theory
of Money 1956
Friedman and
Monetarism
• Restatement of the quantity theory in
the framework of consumer choice
theory
• Demand for money will depend on
total wealth, the prices and returns
on various types of assets, and
consumer preferences
• Demand for real money balances is
stable
• Increases in money supply will have
only a temporary effect on i rates
and expenditure
• Longer run effect on the price level
Friedman and
Monetarism
• Monetary authorities cannot peg
interest rates
• Monetary rule—keep the rate of
growth of the money supply
equal to the long run rate of
growth
• This will generate price stability
• Monetarist policies introduced
did eventually squeeze out
inflation but at the cost of a
significant recession and high
interest rates in the short run
Keynesianism,
Monetarism and
Econometrics
• Keynes himself was skeptical
about econometric methods
• But Keynesian models could be
empirically estimated
• National income data etc
• Cowles Commission, and
structural Keynesian Models
• Friedman’s critique—simple
models and predictive ability
• Cowles versus Chicago
The Present State
• “Keynesian” models—short run
models with various types of
market imperfections
• Long run models of a more
“classical” character—rational
expectations, policy neutrality
• More emphasis on long run
issues of government debt,
growth, intergenerational issues
• Central banks and inflation
targets