Transcript John Keynes

John Maynard
Keynes
Presentation by Russell Baker, Caitlin Buckvold,
Zachary Hanson, and Max Shaugnessy
April 10, 2012
Presentation Outline
• Section I
o Historical context, Keynes’ early life, career path
• Section II
o Major Works – Economic Consequences of the Peace, Treatise on Money
o General Theory of Employment, Interest and Money
o Academic Influences
• Section III
o Critiques of Keynesianism and modern applications
Section I
What factors influenced Keynes’ General Theory?
John Maynard Keynes
“Ideas shape the course of history.”
Life: June 5, 1883 – April 21,
1946
• Born and raised in England
Family:
• Father – Robert Neville
Keynes
• Mother – Florence Ada
Keynes
• Brother – Geoffrey Keynes.
Knighted for work on blood
transfusion, married
granddaughter of Charles
Darwin
• Sister – Margaret Keynes.
Married Noble Prize winning
Physiologist
Early Life
Florence Ada Keynes
• Social Reformer and
Mayor of Cambridge
• Ran numerous charities:
o Provided pensions for elderly
living in poverty
o Provided services for
“deserving” poor
o Reintegrated inmates back into
society
• Loving mother,
devoted to Keynes
John Neville Keynes
• Economist and Lecturer
in Moral Sciences at
Cambridge University
• “Positive Economy”
• “Normative Economy”
• “Art of Economics”
• Loving father, devoted
to Keynes
• Studied at Eton and King’s
College, Cambridge
o In 1904, earned B.A. in
Mathematics
• President of the Cambridge
Liberal Club
o Promoted redistribution of
wealth
o Favored government
involvement in the economy
• Member of Cambridge Apostles
o Creepy, secret-society
o Debating forum for members
that included many prominent
mathematicians and
philosophers
Keynes’ Life
Education
• Clerk for India Office,
1906-1908
• Lecturer and Researcher
on probability theory at
Cambridge, 1909-1913
o Published a series of
articles on the Indian
economy
o First book: Indian Currency
and Finance, 1913
• Treasury, 1915
o One of the negotiators for
terms of Versailles Peace
Treaty
Keynes’ Life
1906-1915
World War I
• Treaty of Versailles
o Britain, France, and USA
responsible for negotiating
terms of treaty with Germany
o Keynes working behind the
scenes
• Terms of Treaty
o Astronomical reparations
o Crippled German economy
• Keynes’ Beliefs
o Reparations should be minimal
o Need to protect German
citizens from starvation
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Unemployment Rate (%)
Unemployment in Great Britain (1900-1950)
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Unemployment rates had an enormous amount of
influence on Keynes’ arguments
• Treatise on Probability, 1921
o First, large mathematical work by
Keynes
• Becomes an investor and
currency speculator
o Very wealthy by the end of the
1920s
• Advocates against the Gold
Standard
o Believes that, to decrease
unemployment, Churchill should
devalue the British Sterling
• Continues to work as a lecturer
at Cambridge University
Keynes’ Life
1920-1930
• Keynes loses most of his
fortune after the Great
Depression
• A Treatise on Money, 1930
o Describes why
unemployment persists at
such high levels
• Critical of British austerity
measures during
Depression, advocates for
increased government
spending
Great Depression
• Britain abandons Gold
Standard, 1931
• Keynes re-earns fortune
through sales of the
General Theory and
currency speculation
• Keynes’ health begins
to fail
• Economic Adviser to
the British Government
Keynes’ Life
1930s
The General Theory
of Employment,
Interest and Money
•
Keynes’ Masterpiece
•
Hugely influential across
the world
•
Foundation of
Keynesianism
• Keynes negotiates with USA
to secure loans to Britain
during wartime
• Argues that the taxes should
be increased and a
mandatory savings rate
established to pay for the
War
o Avoid inflation after War’s
end
• Keynes, now a Baron, takes
a seat in the House of Lords
among the Liberal Party
• Advocates new monetary
system after the War
Keynes’ Life
1940s, World War II
• Established IMF and
pre-cursor to the
World Bank
(International Bank for
Reconstruction and
Development)
• Establishes a world
monetary system of
fixed exchange rates
tied to the US dollar
Bretton Woods
What factors influenced
Keynes’ General Theory?
1. Family
2. Education at
Cambridge
3. Government Service
4. World War I
5. Great Depression
“[With Bretton Woods]… we
have shown that a concourse
of forty-four nations are
actually able to work together
at a constructive task in amity
and unbroken concord. Few
believed it possible. If we can
continue in a larger task as we
have begun in this limited
task, there is hope for the
world.”
- John Maynard Keynes
Section II
Keynes’ Major Works
The Economic
Consequences of
the Peace
“If we aim deliberately at
the impoverishment…
nothing can then delay for
very long that final war
between the forces of
Reaction and the despairing
convulsions of Revolution,
before which the horrors of
the late German war will
fade into nothing.”
- John Maynard Keynes
• France
o Wanted to set back German
progress 50 years
• United States
o Woodrow Wilson left Washington
“enjoying a prestige and moral
influence unequalled in history”
o In fact, weak-minded and not
knowledgeable of European
conditions
• The French succeeded in
achieving many of their
demands
The Economic
Consequences of
the Peace
Versailles Conference
Overview
• Treaty of Versailles, 1919,
crippled German economy
• Keynes’ proposals overlooked,
considered controversial
• Wrote The Economic
Consequences of Peace in two
months the following Summer of
1919
• The Economic Consequences of
Peace was largely a critique of
the Treaty of Versailles
The Economic
Consequences of
the Peace
The Treaty of Versailles
Overview
• Europe cannot prosper
without an equitable,
integrated economic
system
• The Allies violated the
Fourteen Points: a
commitment fairness
regarding reparations,
territorial adjustments, and
economic matters
The Economic
Consequences of
the Peace
The Treaty of Versailles
Criticism
• Reparations were severe,
exaggerated, and
questionable
• Inflation hit Europe hard, with
Germany experiencing
hyperinflation
• Keynes attributed the
hyperinflation to
governments being too
short-sighted to secure loans
or taxes from resources they
acquired, (and instead)
have printed notes for the
balance”
The Economic
Consequences of
the Peace
The Treaty of Versailles
Aftermath
• Keynes claimed the
Treaty did not include
a rehabilitation plan
to the European
economy
• Three key problems
1. Decline in Europe’s internal
productivity
2. Breakdown of transportation
and infrastructure
3. Inability to import goods and
supplies from overseas
The Economic
Consequences of
the Peace
Europe after the War
• Keynes suggested a
plan to help remedy
the situation:
1. Revising the treaty and
reparations
2. Abandonment of inter-ally
Indebtedness
3. An international loan
4. European relations with Russia
The Economic
Consequences of
the Peace
Solving Europe’s Problems
• The Economic
Consequences of Peace
became an immediate
bestseller on both sides of
the Atlantic
• Solidified Keynes’ reputation
as a leading economist
• Public perceived Germany
was being treated unfairly,
resulting in public support for
appeasement
• Keynes predicted the next
war would begin twenty
years from 1919
The Economic
Consequences of
the Peace
Success and Influence
A Treatise on
Money
• Published in 1930,
written during the
beginning stages of the
Great Depression
• A Treatise on Money
professed his views on
money, interest, and
monetary policy
• Many of his views were
borrowed from his
mentors, Alfred Marshall
and Arthur Pigou
A Treatise on
Money
Background
• Keynes’ introduced his theory
that where saving exceeds
investment, recession will occur
• Keynes suggested that in order
to stabilize the economy, the
price level must first be stabilized
• Government Central Bank
lower interest rates when
prices rise, raise interest rates
when prices fall
• Many of his ideas are further
developed in his future work,
General Theory
A Treatise on
Money
Monetary Policy
Classical Theory
Keynes
• Critically acclaimed as a hard to
read, and many of the concepts
were a work-in-progress
• Hayek wrote three reviews and
critiques on A Treatise on Money
• Their debates / critiques largely
revolved around discrepancies
in terminology, especially as it
pertained to saving and
investment models
• Both were promising economists
aspiring to develop economic
models / theory
A Treatise on
Money
Reception
• A Treatise on Money
served as a prequel to
his greatest
masterpiece – The
General Theory of
Employment, Interest,
and Money.
• Many fundamental
concepts within
General Theory were
more polished ideas
from A Treatise on
Money
A Treatise on
Money
Legacy
The General Theory
of Employment,
Interest and Money
“It is astonishing what foolish
things one can temporarily
believe if one thinks too long
alone, particularly in
economics”
- John Maynard Keynes
• The General Theory was written
during the Great Depression,
published in 1936
• Keynes introduces the book with
the radical claim that The
General Theory is meant to
contrast his arguments with
those of classical theory of
economics
• Keynes claims that classical
economics are applicable to
only special cases, which
“happen not to be those of the
economic society in which we
actually live”
The General
Theory on
Employment,
Money and Interest
Book I
Introduction
• Classical theory of employment says
the labor market is determined by
supply & demand, where
unemployment strictly caused by
either frictional unemployment or
voluntary unemployment
• Doesn’t explain Great Depression
o
People must simply work for less?
• Classical Theory – supply creates its
own demand. If there are people
willing to work, jobs will be created
to use them
o
Unemployed is a result of refusal to work
The General
Theory on
Employment,
Money and Interest
Book I
Introduction
1. The real wage is equal
to the marginal
disutility of the existing
employment;
1. There is no such thing
as involuntary
unemployment in the
strict sense; and
1. Supply creates its own
demand (Say’s Law)
The General
Theory on
Employment,
Money and Interest
Book I
The Classical Assumptions
1. Workers and unions will
protest nominal wage
reductions, but not real
wage reductions under the
classical school
o Inflation a better solution than wage
cuts?
The General
Theory on
Employment,
Money and Interest
Book I
A Critique of Classical Labor
2. If wages decrease, cost of
production decreases, then
prices decrease  real
wages stay the same
• Keynes uses this example to
criticize fundamental
assumptions of classical
economics
Model
• People earn money, then
spend some of it – not all of
it, resulting in “insufficient
effective demand”
• Businesses hire based off
how much they expect to
sell
o
Spending determines employment, supporting
the idea of unemployment
• The existence of “insufficient
effective demand” will often result
in less-than optimal unemployment
levels, despite that marginal
product of labor > marginal disutility
of employment
The General
Theory on
Employment,
Money and Interest
Book I
Effective Demand
• These two fundamental
concepts left Keynes
baffled as to how classical
Ricardian economics is
considered “complete”
and “victorious”
The General
Theory on
Employment,
Money and Interest
Book I
Criticism of Classical
Economics
• “It may well be that the
classical theory represents
the way in which we
should like our economy
to behave. But to assume
that it actually does so is
to assume our difficulties
away.”
• Prospective yield: value of
expected returns – cost of
inputs and maintenance
• Supply price: cost of
manufacturer making new
machine (replacement
cost)
Marginal Efficiency of
Capital
=
prospective yield – supply
price
The General
Theory on
Employment,
Money and Interest
Book IV
Marginal Efficiency of
Capital
• Increasing investment in capital
has two effects:
o Decreases prospective yield in
the long run
o Increases supply price in short
run
 Overall diminishing the marginal
efficiency
• Investment-demand schedule:
how much investment must
increase to lower ME to a given
level
• Investment will be pushed until
ME (general) = market interest
rate
The General
Theory on
Employment,
Money and Interest
Book IV
Marginal Efficiency of
Capital
• Changes in value of money
affect expected yield
Expect inflation  yield
increases attracting more
investment
And vice versa
• No way to predict long-term
expected yields
• “Beat the gun” in stock
markets
• Instability due to “animal
spirits”
The General
Theory on
Employment,
Money and Interest
Book IV
Marginal Efficiency of
Capital
• Interest rates are the price
people demand for parting
with their money
• Depends on:
o liquidity preference (desire to
hold cash)
o money supply
• Driven by bond market
speculation
o expected increase in r  hold
cash now, buy bonds later
• People believe saving lowers
interest rates when really it
lowers demand and
increases unemployment
The General
Theory on
Employment,
Money and Interest
Book VI
Interest Rates
Increases
liquidity
preference
Increase MS
Increases
prices
Decreases r
Increases
employment
Increases
investment
• Central bank can lower shortterm rates by printing money
buying short-term government
debt
o US did this in Great Depression
• To extend this to long-term rates,
government should buy longterm bonds
• Larger amount of cash they seek
to create by purchasing
bonds/debt, greater the fall of r
• Monetary policy seen as
experimental will not delivery
long-term reduction of r
o it will only increase
“precautionary motive” of
holding cash
The General
Theory on
Employment,
Money and Interest
Book IV
Controlling the Interest Rate
• Liquidity traps
• Rates fall so low that
everyone prefers holding
cash and authority loses
control over the rates
The General
Theory on
Employment,
Money and Interest
Book IV
Problems with Controlling
the Interest Rate
• Hyperinflation – no one
wants to hold cash
• Crises – can’t get people
to want to reasonably part
with their cash
• For full employment,
government keeps r down
by printing money
• More profitable to invest in
things with lower yields
• ME  zero (remember: ME
= yield – supply cost)
• No one would invest in
anything anymore
• Accumulation but no
growth
• The rentier disappears
The General
Theory on
Employment,
Money and Interest
Book IV
Problems with Controlling
the Interest Rate
The General
Theory on
Employment,
Money and Interest
Book V
Changes in money-wages
The employment function
The theory of prices
• Classical argument: A
reduction in wages
stimulates demand
(due to reduced
production costs)
• Keynes’ rebuttal: This
could only be true if
aggregate demand is
fixed
The General
Theory on
Employment,
Money and Interest
Book V
Money-wages, Chapter 19
• The profits realized by
entrepreneurs as a
result of lower
production costs will
be disappointing, and
employment will fall
back to its previous
figure
The General
Theory on
Employment,
Money and Interest
Book V
Keynes’ Analysis
Why the classical moneywage theory doesn’t work
• The reduction of
money-wages will
have no lasting
tendency to increase
employment!
The General
Theory on
Employment,
Money and Interest
Book V
Therefore…
• Propensity to consume
• Schedule of marginal
efficiencies of capital;
(Expected income = Price of capital
asset)
The General
Theory on
Employment,
Money and Interest
Book V
Then which factors are
• Rate of interest
Why?
• Demand
• Investment
related to increasing
employment?
• A flexible money policy
is preferred because it is
easier to implement
• Flexible wage policies
would be unjust,
wasteful, and disastrous
• If labor was in a position
to affect change, then
Trade Unions would rule
monetary policy
The General
Theory on
Employment,
Money and Interest
Book V
Flexible Wage Policy v.
Flexible Money Policy
Which is preferred?
• Short run:
o Stable prices
o Stable employment
• Long run:
o Prices fall slowly as a
result of better
technology, while
wages remain stable
o OR, wages rise slowly
as prices stay stable
The General
Theory on
Employment,
Money and Interest
Book V
Rigid Wage Policies
Why does Keynes believe
wages should be somewhat
rigid?
• Quantity Theory of
Money is not 100%
right
o Emphasis on money
demand
• Recent mathematical
models are “mere
concoctions”
• Deceptive simplicity to
assume A  B.
The General
Theory on
Employment,
Money and Interest
Book V
The Theory of Prices
Chapter 21
• The long-run
relationship between
the national income
and the quantity of
money will depend on
liquidity preferences
o Psychology of the public
• The very long-run
course of prices has
always been upward
The General
Theory on
Employment,
Money and Interest
Book V
Theory of Prices: A
Generalization
Section III
Modern application of Keynes & its critics
• First coined by Milton
Friedman in 1965
• Later repeated by
Richard Nixon in 1971
• “I guess everyone is a
Keynesian in a foxhole”
– Robert Lucas
• Popular phrase
following the financial
crisis and subsequent
bailouts
“We’re all
Keynesians
now”
“We’re All Keynesians Now”
What do modern economists think of Keynes?
• “How Did Economists
Get It So Wrong?” by
Paul Krugman
• “How Did Paul
Krugman Get It So
Wrong?” by John
Cochrane
Saltwater v. Freshwater
• Irrational market
behavior, animal spirits
• Boost consumption &
effective demand
• Return to Keynes. Fiscal
stimulus, re-regulate
finance
• Efficient markets
hypothesis
• Robert Barro’s
Ricardian Equivalence
• The solution is not to
“rehabilitate an eighty
year old book”
Conclusion