Transcript Intermediate Macroeconomics - College Of Business and

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
Why aren’t capitalist economies
self-adjusting?

Policy Contribution
What should government do to
guide the economy?
Keynes’ Background
Applied “Marshallian” economist
 Writer of tracts, not treatises
 Polemicist of the first-order
 “Presuppositions of Harvey Road”

Evaluations of
The General Theory
Fundamentally mistaken
 Carelessly written
 Poorly organized
 Inconsistent
 Work of genius
 Fertile
 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

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



E=C+I
C = f(Y)
I = g(∏e, r)
Consumption – passive (∆Y)
Investment – volatile (∆∏e)
Therefore, Y and L are volatile
Principle of Effective Demand

C = cY






Where 0 < c < 1; the “fundmental
psychological law”
E = cY + I, and in equilibrium, E = Y
Y = cY + I
Y – cY = I or (1-c)Y = I
Y = I/(1-c) and thus ∆Y = ∆I/(1-c)
Income and output change by a
multiple of changes in investment
Interest rate determination




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Interest is a purely monetary
phenomenon
Interest is the reward for parting with
“liquidity”
Liquidity is desirable because of
uncertainty
∆uncertainty
∆Md
∆r
∆r
∆I ; therefore money is nonneutral
Keynes’ Vision
Main Elements of Keynes’
Vision





Demand-side vision
Output and income (Y) is generally not
at the full employment output level (YF)
Both monetary and fiscal policy are
potential means to alter outcomes
Government and the “socialization of
investment”
The Fundamental Fact? Uncertainty
Keynes versus
“Classical”
Economics
Keynes’ Critiques
 Theory
of output and
employment
 Say’s Law
 Quantity Theory of Money
Keynes on Labor Markets


Labor market does not clear and
involuntary unemployment is the
result.
Two arguments:
(1) rigidity of money wages
(2) flexible money wages are not
powerful enough to restore full
employment
W1
P
Begin at full
employment; Y0 = YF.
AS0
Suppose AD falls –
Prices fall from P0 to
P1.
P0
P1
AD0
AD1
w1 w0
W/P
Y1 Y0 = YF
L1
L0
ES
DL
SL
Y
Involuntary
unemployment of LS –
L1 exists.
At w1, employment of
L1 yields an output of
Y1…
LS
L
With nominal wages
fixed at W 1, the real
wage rises to w1.
The QD of labor at w1
is L1.
Y = A F(K,L)
Output is below full
employment.
Rigid Wages




Equilibrium can seemingly be restored
if either W falls or P rises (both reduce
real wage w)
Doubts that W are flexible.
Doubts that falling W can restore
equilibrium.
Increases in AD raise P and restore
equilibrium.
Rigid Wages

Keynes argued reducing W should be
rejected
Wasteful struggle
 Workers desire relative wage stability, not
real wages
 Workers can not collectively reduce
money wages and maintain relative wages


flexible monetary policy preferable

Workers won’t resist real wage reductions
because relative wages remain intact
W1
P
Begin at Y1
AS0
If W falls to W 0 it
would appear that full
employment would
be restored because
real wages fall.
W0
P0
P1
P2
AD0
AD1
w1 w0
W/P
Y1 Y0 = YF
Real wages adjust
downward to w0 and
employment and
output expand back
to L0 and Y0,
respectively.
L1
L0
ES
DL
SL
Y
LS
L
The fall in the real
wage reduces the
short run AS curve
and equilibrium is
restored through a
further fall in P to P2.
Y = A F(K,L)
As P falls, why does
output expand back
to Y0?
Flexible Wages



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.
“Keynes Effect”
Failure of Flexible Wages

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
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
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 denied that interest rates
affect consumption or saving decisions
and denied they are determined in
loanable funds market
Keynes on Say’s Law


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Keynes argued that saving was “not
spending”
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
Keynes on Quantity Theory



Denied monetary neutrality.
Asserted QTM required “Full
employment” or vertical AS; when Y <
YF, 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.
Keynes on Quantity Theory


Speculative motive in liquidity
preference means demand for money
and therefore V not constant.
Because both V and Y vary,
∆M
∆P; ∆M can also ∆V and ∆Y
Three Interpretations
 “Hydraulic”
Keynesianism
 “Fundamentalist”
Keynesianism
 “Modified General
Equilibrium Approach”
Three Interpretations

“Hydraulic” Keynesianism
Focuses on W, P and r rigidities
 IS/LM model of Hicks, Modigliani, and
Samuelson
 “Orthodox Keynesianism”


Neo-Classical Synthesis
Weakness: why rigidities?
 New Keynesians supply answer

Three Interpretations

“Fundamentalist” Keynesianism
Focuses on uncertainty and income
effects
 Rejects the Principle of Gross Substitution
 Shackle, Robinson, Davidson
 Post Keynesian economics

Three Interpretations

“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
 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
Methodology and Philosophy
Treatise on Probability (1921)
Uncertainty, knowledge, ignorance and
probability
 Given support to both Fundamentalist
and General Disequilibrium approaches to
understanding Keynes
