Transcript Keynesian Economics Slides

Keynes
and the Keynesians
ECON 205W
Summer 2006
Prof. Cunningham
John Maynard Keynes
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Born in 1883 in Cambridge, England
Son of John Neville Keynes
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Neville was a professor of Economics and Logic at Cambridge
Univ., and wrote on Economic Methodology
Won a scholarship to Eton
Boy Genius
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(1883-1946)
Won prizes for his work in the classics, mathematics, history,
English essays
Wrote papers on contemporary social problems, participated
in crew and debate, acted, read everything
Became an expert in medieval latin poetry
Part of Eton’s social elite
Won a scholarship to King’s College, Cambridge
Keynes at College
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President of the Student Union
President of the University Liberal Club
Rowed, studied philosophy, played bridge,
visited art galleries, collected rare books, went
to the theatre
Became a member of the “Apostles”, a secret
and highly exclusive Cambridge intellectual
society
Became a member of the literary set called
“the Bloomsbury Group.”
Keynes After College
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Studied economics for perhaps 1 year, but did
poorly on his exams.
Took a civil service exam and took a job at the
India Office for 2 years.
1908, his father managed to get him a job as a
lecturer at King’s College. Later he became a
Fellow.
1911, he became editor of the Economic Journal.
Worked at the Treasury during WWI.
1921, he published A Treatise on Probability. This
was his dissertation. It won him a fellowship at
King’s College, Cambridge.
Marries Lydia Lopokova.
Keynes, Inter-war Years
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Keynes wrote the Economic Consequences of the Peace
(1919), regarding reparation payments
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Best Seller
Made him a public celebrity
1923, Tract on Monetary Reform (against returning to
the pre-war gold standard)
Economic Consequences of Mr Churchill (1925, warned
of depression)
1930, Treatise On Money
Makes millions in the stock market, commodity, and
forex markets.
1936, General Theory of Employment, Interest and
Money
1937, he has a serious heart attack
Keynes’ Tract
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Relates money supply variability and
uncertainty to inflation and deflation.
Variability of prices is a major cause of
business cycles.
Wages and other costs of production
adjust more slowly than prices.
Therefore price variability affects profits
and therefore investment.
Investment cycles cause business cycles.
Keynes’ Treatise on Money
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Early elements of the General Theory.
Expectations are quasi-rational?
Swings in investment, based on changes in
profits, generate business cycles.
Saving is passive.
Introduces a stock-flow analysis.
Written following Britain’s return to the gold
standard at parity in 1925.
Argued that under a fixed gold standard, there
is no opportunity for independent domestic
policy.
The General Theory
“ I believe myself to be writing a book on
economic theory which will largely
revolutionize—not, I suppose, at once
but in the course of the next ten years—
the way the world thinks about economic
problems.”
-- John Maynard Keynes
Comment by Paul Samuelson
“It is a badly written book, poorly organized; any layman who,
beguiled by the author’s previous reputation, bought the book
was cheated of his 5 shillings. It is not well suited for classroom
use. It is arrogant, bad-tempered, polemical, and not overlygenerous in its acknowledgements... In it the Keynesian system
stands out indistinctly, as if the author were hardly aware of its
existence or cognizant of its properties; and certainly he is at his
worst when expounding on its relations to its predecessors.
Flashes of insight and intuition intersperse tedious algebra. An
awkward definition gives way to an unforgettable cadenza. When
it is finally mastered, we find its analysis to be obvious and at the
same time new. In short, it is the work of genius.”
The General Theory
1.
If the consumer is an economic optimizer,
he/she must be unable to buy the goods they
planned to buy because of some kind of
constraint—risk, convention, social institutions,
cash, or ...?
a)
b)
c)
d)
According to the classical model, the consumer has
insatiable wants.
The consumer sells his/her labor in exchange for
enough income to buy the goods.
The money value of the incomes received must be
equal to the value of the output produced.
So how can unsold goods pile up in warehouses,
causing firms to lay off workers?
The General Theory (2)
2.
Say’s Law cannot hold. (“Supply
creates its own demand.”)
a)
b)
If spending constraints are in effect,
then there will be a difference
between (unlimited) demand and
“effective demand”.
Actual (effective) demand will usually
be “deficient” to purchase total
output.
The General Theory (3)
Microeconomics and macroeconomics do not
operate on the same basis. One cannot
assume that what is true for the economic
agent at the level of the individual consumer or
firm is true in aggregate. This amounts to the
fallacy of composition.
3.
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In microeconomics, relative price effects dominate.
This is not true in macroeconomics. In
macroeconomics, income effects dominate, making
income more important in determining aggregate
economic behavior.
The General Theory (4)
4.
Therefore, consumption depends
primarily upon income, not
interest rates.
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C  C(r), but rather C = C(Y)
“People don’t change their standard of living
simply because the interest rate changes a
few points.”
The General Theory (5)
Saving occurs as the result of a habit,
convention, or social norm. People on average
set aside a certain percentage of their
income. Saving is not a function of interest
rates.
5.
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S  S(r), but rather S = S(Y)
Investment is related to interest rates, but
also to businesspeople’s expectations for the
future.
6.
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That is, I = I(r,E).
The General Theory (6)
If S = S(Y) and I = I(r,E), then there is no
coordinating variable to bring supply and demand
together in the loanable funds (capital) market.
7.
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There is no reason to assume that supply equals
demand in this market.
There is no reason to believe that there will be adequate
funds available to provide adequate investment demand.
Since AD = C + I + G + NX, if investment demand is
deficient, then AD < AS, and inventories may pile up,
with unemployment a natural outcome.
Without the coordinating variable, this will be the normal
outcome, with AD = AS only happening accidentally.
The General Theory (7)
8.
Investment is a large and long-term
commitment, and is based on weakly
supported expectations about the future.
This makes investment very different from
consumption. Investment decisions will be
erratic and emotional, and the risks
associated with investment are very high.
As a result, business decision makers will
tend to under-invest, further worsening the
problem of deficient investment.
The General Theory (8)
9.
It may be a natural outcome of the
organization and institutions of
modern economies that prices and
wages may not be fully flexible. This
would result in markets (like the labor
and goods markets) being unable to
clear, leading to unemployment and
aggregate supply exceeding demand.
The General Theory (9)
Money plays a key role in the economy. The
use of money leads to uncertainty, and makes
“piercing the veil” impossible. A money
economy is fundamentally different from a
barter economy. The classical dichotomy
cannot hold.
10.
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11.
Interest rates are established in the money market.
People may rationally hoard money, holding money
for purposes other then making transactions.
Equilibrium is not AD = AS. It is a state that
persists.
Consumption
Consumption
7000
6000
5000
4000
3000
2000
1000
0
0
2000
4000
6000
Real GDP
U.S. Annual Data, 1929 - 2001
8000
10000
Consumption Function
c = mpc = C/Yd = marginal propensity to consume
C
C
Yd
C = C0 + mpc x Yd
Or
C = C0 + cYd
C0
Yd
Original Aggregate
Expenditure Model
Z=AS
Nominal Value
of Output (Py)
C
E*
N*
Nf
De = AD
There is a limit to the
profitable expansion of
output. If Say’s Law held,
there could be no obstacle
to full employ-ment. Output
could profitably be
increased until excess labor
was absorbed. Thus, this is
a refutation of Say’s Law.
Aggregate planned expenditure
(trillions of 1992 dollars/year)
o
45 line
Real GDP exceeds
planned expenditure
10.0
Total Expenditure
C+I+G
8.0
f
6.0
b
4.0
c
a
Equilibrium
expenditure
Planned
expenditure
exceeds
real GDP
C0
G
I
0
e
d
2
4
6
8
10
Real GDP (trillions of 1992 dollars per year)
Algebra of the Model
Y=C+I+G
but C = C0 + c(Y-T), so
Y = C0 + c(Y-T) + I + G
Y = C0 + cY – cT + I + G
Y – cY = C0 + I + G – cT
Y(1-c) = C0 + I + G – cT
1
C0  I  G  cT 
Y* 
1 c
But this means that
1
Y 
G
1 c
1
Y 
I
1 c
1
Y 
C
1 c
but
c
Y 
T
1 c
Policy
Planned
Expenditures
E
1
E
0
G
Y0
Yf
Y
Alvin Hansen (1887-1975)
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Background
Taught at Brown Univ., Univ. of Minnesota, and
finally Harvard (1937)
Famous students
Wrote a paper pointing out a math error in
Keynes’ Treatise on Money; not enthusiastic
about the General Theory at first.
Business Cycle Theory (1927)
1941, Fiscal Policy and Business Cycles
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Extended Keynes’ Policy Recommendations
Supported Keynes’ analysis of the 1930s
A Guide to Keynes (1953)
Hansen (2)
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Hicks-Hansen Synthesis (IS-LM)
r
LM
r*
IS
y*
y
Hansen (3)
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Hicks (1939) had pointed out problems with
Keynes’ theory, utilizing his own IS-LM
apparatus. Hicks and Hansen worked out the
indeterminacy of the interest rate and other
problems.
Extensive revision of Keynes’ aggregate
expenditure model.
1937-38, Advisory Council on Social Security
Economic advisor to Federal Reserve Board
Participated at Bretton Woods
Involved in the Full Employment Act and the
creation of the Council of Economic Advisors
Hansen (4)
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Stagnation Thesis
1938, Full Recovery or Stagnation
 Inadequacy of investment of keep
pace, making it impossible for the
economy to naturally maintain full
employment
 Advocated (gov’t) compensatory
finance to compensate for inadequate
private sector investment
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Abba P. Lerner (1903-1982)
Background
 Taught by John R. Hicks, Lionel
Robbins, von Hayek
 Socialist at London School
 Focus on policy recommendations,
including functional finance.
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Paul Samuelson (1915- )
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1970, 1st American Nobel in Economics
Textbook, Economics
PhD, Harvard
Phillips Curve with Solow
wage
inflation
Consumer
price
inflation
u
Phillips’ curve
u
Samuelson-Solow Curve
Samuelson (2)
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Contributions
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Comparative statics
Revealed preference theory
Efficient markets hypothesis
Product and factor mobility
Public goods theory
Methodological innovations
Use of mathematics
• Called economics “full of inherited contradictions,
overlaps, and fallacies.”
• Dissertation Foundations of Economic Analysis,
published in 1947.
Samuelson (Accelerator)
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The desired capital stock is proportional to the
level of output:
K td  Yt
Investment is the process of moving from the
current level of capital to a desired level:
I n,t  K td  K t 1
We assume that whatever the capital stock
ended up being last period was the level of
capital that businesses actually wanted:
K t 1  K td1  Yt 1
Accelerator (2)
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This allows us to rewrite:
I n,t  K td  K t 1
As
In,t  K td  K t 1  Yt  Yt 1   (Yt  Yt 1 )
In,t  Yt
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Thus investment is related to the rate of
change in output.
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If the economy is growing rapidly, then investment
grows rapidly.
If the economy is not growing, then investment
slows, and net investment (after depreciation) may
actually be negative.
Post Keynesians
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Sraffa, Robinson, Pasinetti, Weintraub, Davidson
Neo-Ricardian view of production, value, and
distribution
Oligopolistic corporations. markup pricing
Endogenous money
Cyclical instability
Incomes policy
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Class struggle for income shares, markup pricing
necessitate a permanent incomes policy
New Keynesians
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Fischer, Taylor, Howitt, and many others
Rational expectations, general
equilibrium, microfoundations
Offer theoretical support at the firm profit
maximization level for Keynesian features
in the economy
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Contracting models
Menu/transactions costs
Efficiency wages
Insider-Outsider theory