Transcript Dissent on Keynes: A Bridge to Friedman and Hayek

Dissent on Keynes
A Bridge to Milton Friedman’s Monetarism
And to F. A. Hayek’s Capital-Based Macroeconomics
Is government policy the source
of macroeconomic instability?
Roger W. Garrison
2011
EXPENDITURES
C = a + bY
INCOME
Yfe
CONSUMPTION
C+I
INVESTMENT
The nature of the Keynesian-styled spiraling associated with
recession, depression and inflation becomes more transparent
with the production possibility frontier in play.
W
S
Also, the PPF gives analytical
legs to the views of Keynes’s
opponents---to Milton Friedman’s
Monetarism and F. A. Hayek’s
D
Capital-based Macroeconomics.
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EXPENDITURES
C = a + bY
Yfe
INCOME
CONSUMPTION
C+I
INVESTMENT
A waning of animal spirits causes
investment to decrease and with it
income and consumption. The
economy falls inside its PPF.
W
S
D
N
C = a + bY
Yfe
INCOME
CONSUMPTION
EXPENDITURES
C+I
INVESTMENT
Note that if investment
A further
were towaning
fall to zero,
sendsthe
theeconomy
economywould
settle into an income-expenditure
deeper into the
equilibrium
PPF’s interior.
with Y = C.
Movements inside the frontier (and beyond
Thus,
the
vertical
intercept
of the Keynesian demand constraint
W
it) trace out a linear relationship, showing
is aligned withS the intersection of the consumption function and
how consumption varies with investment.
the 45o line.
D
The straight line that passes through these
N
points is the Keynesian demand constraint.
C+I Y = C + I
where, in equilibrium,
Hence, C = a + b(C + I)
C = a + bY
So, C = a + bC + bI
C – bC = a + bI
CONSUMPTION
EXPENDITURES
C = a + bY
(1–b)C = a + bI
C =
[a /(1-b)]+[b /(1-b)]I
Yfe
INCOME
INVESTMENT
Note that each of the four points that define the economy’s spiral path
constitute an actual or potential Keynesian equilibrium. At each of those
equilibrium points, Y = C + I.
We also know that C = a + bY.
But rather than use these two relationships to solve for the equilibrium level
of income, let’s use them to determine the implied relationship between
investment spending and consumption spending.
EXPENDITURES
C+I
C = a + bY
CONSUMPTION
a
b
C = (1 – b) + (1 – b) I
b
1–b
a
(1 – b)
Yfe
INCOME
INVESTMENT
For simplicity, let a = 0 and b = 0.90. Then C = a + bY becomes C = 0.90Y.
C = a/1-b)+ b/1-b)I becomes C = 9I, which led Keynes to write:
C =
[a /(1-b)]+ [b /(1-b)]I
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Keynes denied that there are viable market
forces that can move the economy along
the Production Possibilities Frontier.
CONSUMPTION
Keynes argued that it is the instability of
investment spending and, in particular, the
waning of “animal spirits” that sends the
economy spiralling into recession.
By similar reasoning, Keynes realized, a
waxing of animal spirits (known today as
“over exuberance”), will set off an
inflationary spiral.
INVESTMENT
Policymakers, in Keynes’s view, should
prescribe fiscal and monetary policies aimed
countering these destabilizing forces that
are inherent in market economies.
Friedman didn’t doubt that there are viable
market forces that can move the economy
along the Production Possibilities Frontier.
But he considered those movements to be
largely irrelevant to macroeconomic issues.
CONSUMPTION
Friedman argued that it is the central
bank’s propensity to create money that
accounts for inflationary spirals.
By similar reasoning, Friedman realized, a
shrinking (or collapse) of the money supply
will cause the economy to spiral into
recession (or depression).
INVESTMENT
Central banks, in Friedman’s view, should
abstain from pro-actively managing the
macroeconomy and, instead, should
increase the money supply year-in and
year-out at a rate that maintains long-run
price-level stability.
CONSUMPTION
Hayek didn’t doubt that there are market
forces that can move the economy along the
Production Possibilities Frontier. And he
considered these forces to be viable---but
only if the central bank abstaines from
manipulating interest rates.
Hayek argued that an increase in saving,
which finances more investment, will lead
the economy clockwise along its
production possibilities frontier.
Similarly, a decrease in saving (and hence
an increase in consumption) will lead the
economy in a counter-clockwise direction.
INVESTMENT
In Hayek’s view, when the central bank lowers
interest rates (without there being any
increase in saving), it misleads the economy.
Resources get misallocated during a policy
driven boom, which eventually end in a bust.
Dissent on Keynes
A Bridge to Milton Friedman’s Monetarism
And to F. A. Hayek’s Capital-Based Macroeconomics
Is government policy the source
of macroeconomic instability?
Roger W. Garrison
2011