Transcript philips curve

LECTURE NOTES ON MACROECONOMICS
ECO306
SPRING 2014
GHASSAN DIBEH
Chapter 8
Keynesian Instabilities
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
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Positing the Keynesian revolution as IS-LM plus Phillips curve laid the foundations
for the revival of classical theory once assumptions about inflationary
expectations (adaptive then rational) and wage and price flexibility were
combined to deal a severe blow to Keynesian economics.
The Neoclassical synthesis ushered a period in which most economists agreed on
a common framework for macroeconomic analysis and policy. The shapes of the IS
and LM functions were assumed to be ‘normal’ (no flat LM, no vertical IS,…) and
the IS and LM functions and the Phillips curve were largely stable.
The monetarist and RE counter attack by undermining the foundation of the
Phillips curve has led waste to both Keynesian economics and the Neoclassical
synthesis.
New Classical Macroeconomics, although not the harbinger of the
macroeconomic consensus of the Great Moderation, it was, however, a main
ingredient or the specter that guided the Great moderation’s macroeconomic
policy.
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This chapter will look at Keynesian economics from a different perspective, one
that was lost in the Hicksian interpretation of the General Theory. At the
beginning though we look at the countervailing forces that may nullify the
‘Keynes’ and ‘Pigou’ effects. This is a very important element of any economic
theory of macroeconomic dynamics.
Once wages and prices are assumed flexible, the following question posits itself:
Do price and wage flexibility restore full employment equilibrium if the
economy is knocked off of it?
Keynes in the General Theory relaxed his early assumption on the rigidity of
wages and prices in the capitalist economy then proceeded to show that in the
presence of the liquidity trap, the ‘Keynes’ effect would be ineffective and that in
the presence of adverse deflationary expectations, the downward spiral of
wages and prices would actually intensify the depression rather than cure it.
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Irving Fisher, a contemporary of Keynes also advanced a theory of
debt deflation that showed that deflation actually makes the
depression more severe rather than less.
In addition, James Tobin in the 1970’, and 1980’s advanced the idea
that the Keynesian revolution must be understood in a ‘dynamic’ context
not a ‘static’ one. The Keynesian underemployment is a dynamic
phenomenon and not a static one. The disequilibirating adverse
expectations that deflations induce cause the economy to spiral away
from full employment. Under such dynamics, the Pigou effect is nullified
and the classical stationary state is unattainable.
Keynes nullifies the ‘Keynes’ Effect
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Keynes himself after introducing what came to be known later as the
“Keynes Effect” was not very optimistic about the efficacy of the
effect in generating full employment equilibrium as deflation occurs.
Keynes argued that in a situation of deep recession, interest rates
may drop to a low level so that a liquidity trap may exist.
A liquidity trap is a state of the economy where all increases in the
money supply are held as “hoard” or are absorbed in the speculative
demand for money. This makes the speculative demand for money
infinitely elastic (𝑐2 → ∞). Under such conditions, the LM curve
becomes flat at low levels of output and interest rates.
Keynes nullifies the ‘Keynes’ Effect
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∆
𝑀𝑠
𝑃
→ No Shift in LM
⇒ ∆𝑦𝐸 = 0 𝑎𝑠 𝑎 𝑟𝑒𝑠𝑢𝑙𝑡 𝑜𝑓 ∆𝑃 < 0.
Keynes nullifies the ‘Keynes’ Effect
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Another state of the economy may nullify the Keynes effect if
investment is not sensitive to the interest rate. If 𝐼 ≠ 𝐼(𝑟), then a shift
in the LM function to the right as a result of deflation will have no or
only a very minimal effect on output.
Given that in a depression or a very
severe recession, both of the above
conditions may hold then the Keynes
effect would be ineffective in
automatically operating to push the
economy into full employment and end
the recession.
The Reverse Pigou Effect
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The notable economist Irving Fisher writing amidst the Great
Depression advanced what came to be known as the Debt-Deflation
Theory of the Great Depression. The theory says that deflation during
the Great Depression was harmful and intensified the downward
dynamic of the economy. This makes deflation an intensifier of
depressions rather than the cure to recessions and depressions as
shown in the Pigou effect.
The Reverse Pigou Effect
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In the economy, there are two kinds of positions: debtors and
creditors.
If the debtors and creditors are not distributed randomly in the
population but creditors are concentrated in the wealthier population
and the debtors in the poorer population, then given that the
marginal propensity to consume by creditors is less than the marginal
propensity of debtors, a Fisher Wealth Distribution Effect will occur as
a result of deflation. When the real value of debt increases as a
result of deflation, consumer-debtors decrease consumption (C) and
business-debtors decrease investment (I).
Given that such losses to aggregate demand are not offset by
creditors, then the Fisher effect will swamp the Pigou effect.
The Reverse Pigou Effect
Expectations and Dynamics: Is Price Flexibility
Stabilizing?
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We have seen that the introduction of price flexibility has led to an
ambiguous result in terms of the final equilibrium state of the economy. Is the
final state of the economy, the Keynesian underemployment equilibrium or
the Pigou full employment equilibrium or what Pigou called the Classical
Stationary State?
This indeterminacy can be summarized as follows:
Keynesian Underemployment Equilibrium
-Weak Pigou Effect
-Weak Keynes Effect
-Fisher Effect Strong
-𝐼 ≠ 𝐼(𝑟)
𝜕𝑀𝑑
𝜕𝑟
=∞
Pigou Classical Stationary State
-Pigou Effect Dominates
Expectations and Dynamics: Is Price Flexibility
Stabilizing?
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So is there a way out of this theoretical impasse?
The empirical record or historical experience has been interpreted in
different ways. It will be discussed later in chapter on
macroeconometrics. For now, the theoretical impasse is discussed in terms
of further theory this time by taking into account dynamic considerations.
Up till now all the macroeconomic models discussed are static models
defined in terms of equilibrium states and changes are actually “jumps”
form one equilibrium state to another as a result of a change in some
exogenous variable (G, T, M, P,…).
Under such a static assumption, many argued (including economists
sympathetic to the Keynesian theory) that the Pigou effect dominates
and that the Classical Stationary State is the only “stable” equilibrium of
the economic system.
Expectations and Dynamics: Is Price Flexibility
Stabilizing?
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The classicals argued that as long as a cut in the price level leads to
higher output and employment (however slight), and since prices can
go down with no limits, then the economy will eventually move to full
employment. The Keynesians have persistently argued against this
“eventual” possibility.
The reduction in the price level necessary to make the Pigou effect
dominate and push the economy towards full employment as Wassily
Leontief quipped would make the economy worth a dime! Which is
an impossibility!
A more relevant criticism was the role that expectations would play
under such price dynamics.
Expectations and Dynamics: Is Price Flexibility
Stabilizing?
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Lawrence Klein early on (in 1947) wrote against such a possibility
by bringing in deflationary expectations into the model of the
economy. He said that the classicals “have argued themselves directly
into a trap” and that the effects of unlimited wage cuts and a
proportionate decrease in nominal product prices will be “those of the
economics and hyper-deflation and social revolution….. (where)
adverse expectations must certainly occur…production plans would
be postponed. This process would have to stop…The method of
stopping it would be the overthrow of the capitalist system”.
Hence according to Klein, hyper-deflation (that the classical
economists were willing to admit to be necessary for bringing about
the Classical stationary state), will trigger adverse expectations that
would deviate the economy further away from full employment rather
than the other way around.
Expectations and Dynamics: Is Price Flexibility
Stabilizing?
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James Tobin has championed such an approach to the question
dealing with the stabilizing or destabilizing effect of price flexibility
in contrast to the hitherto comparative static approach of comparing
the state of the economy under two different price levels 𝑃1 and 𝑃2
where the jump from 𝑃1 to 𝑃2 is assumed to be instantaneous with no
price trajectory along the time it takes 𝑃1 to get to𝑃2 .
This according to Tobin is the implicit assumption made by both New
Classical models and New Keynesian Models. He said that for these
theorists “the possible instability of the price adjustment process is an
embarrassment. They tacitly avoid it by assuming perfect flexibility, so
that after surprise shocks, prices jump to their new equilibria without
passage of time.”
Expectations and Dynamics: Is Price Flexibility
Stabilizing?
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What is important for Tobin (and Keynes of course) is the dynamic
trajectory of the economy through time for answering the question:
does the economy stabilize after a shock that deviates it from full
employment as a result of price flexibility or is price flexibility
destabilizing further pushing the economy away from full
employment towards a state of Great recession or Depression?
Tobin argued that “the question applies to real time and sequential
processes. Therefore the static long-run ‘Pigou-effect’ does not entitle
any one to give a positive answer…. (to the question)…does the
market economy unassisted by government policy, possess effective
mechanisms for eliminating general excess supply of labor and
productive capacity.”
Dynamic IS-LM models with expectations
On the road to dynamics: a ‘static’ IS-LM model with expectations
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First, when we want to include expectations into macroeconomic
models, we have to start differentiating between nominal and real
interest rates something that we have not done before. The nominal
and real interest rates are related by the Fisher equation:
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
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𝑒
𝑟𝑡 = 𝑖𝑡 − 𝜋𝑡+1
where rt = real interest rate,
it = nominal interest rate
πet+1 = expected inflation at t + 1.
𝑒
𝐼 = 𝐼 − 𝛽(𝑖𝑡 − 𝜋𝑡+1
)
Deriving the IS curve

𝑦𝑡 = 𝐶𝑡 + 𝐼𝑡

𝑒
𝑦𝑡 = 𝐶 + 𝑚𝑝𝑐𝑦𝑡 + 𝐼 − 𝛽(𝑖𝑡 − 𝜋𝑡+1
)

𝑒
𝑦𝑡 = 1−𝑚𝑝𝑐 − 1−𝑚𝑝𝑐 𝑖𝑡 − 𝜋𝑡+1
𝐶+𝐼
𝛽
Dynamic IS-LM models with expectations
On the road to dynamics: a ‘static’ IS-LM model with expectations

Deriving the LM curve, we have now the money demand function as a
function of the nominal interest rate or

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Then the LM curve becomes 𝑖𝑡 =
𝑐1
𝑦
𝑐2 𝑡
−
1 𝑀
𝑐2 𝑃
Graphically the IS-LM model becomes:
An expectation of deflation
𝑒
(𝜋𝑡+1
< 0) will shift the IS curve
to the left and lead to a recession.
A dynamic IS model with adaptive expectations
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In the previous model, the inclusion of expectations in the IS-LM model was
done without the consideration of actual price dynamics. Since deflation is a
dynamic process where the trajectory of price is important, we have to
consider a dynamic model.
A dynamic model with inflationary expectations that abstracts from the LM
function by considering the nominal interest rate to be constant (i.e.
determined exogenously the central bank) can be represented as follows:
𝑦𝑡 =
𝐶+𝐼
1−𝑚𝑝𝑐
−
𝛽
1−𝑚𝑝𝑐
𝑒
𝑖𝑡 − 𝜋𝑡+1
IS
•
𝑖𝑡 = 𝑖
Interest rate rule
•
𝑒
𝑟𝑡 = 𝑖𝑡 − 𝜋𝑡+1
Fisher Equation
•
𝜋𝑡𝑒 = 𝜋𝑡−1
Adaptive Expectation
•
𝜋𝑡 = 𝜋𝑡𝑒 + 𝛾(𝑦𝑡 − 𝑦)
Phillips Curve
A dynamic IS model with adaptive expectations
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Substituting, we get the dynamic system that represents the time evolution of
output and inflation
𝐶+𝐼
1−𝑚𝑝𝑐
−
𝛽
1−𝑚𝑝𝑐

𝑦𝑡 =
𝑖 − 𝜋𝑡

𝜋𝑡 = 𝜋𝑡−1 + 𝛾(𝑦𝑡 − 𝑦)
(5)
(6)
It can be shown that in this system, a negative aggregate demand shock,
say engendered by the collapse of the Philips curve (∆𝐼 < 0) will lead to a
reduction in output as can be seen from equation (5) and by equation (6)
will lead to a reduction in inflation which in turn will feed back into equation
(5) through an increase in real interest rate (term
𝛽
1−𝑚𝑝𝑐
𝑖 − 𝜋𝑡 ) leading to
a further reduction in output which will further reduce inflation and the
above process will repeat itself further pushing the economy away from its
initial equilibrium output.
A dynamic IS model with adaptive expectations
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Hence, in this economy the flexibility of prices has acted as a
destabilizing factor and deflation will further push away the economy
from equilibrium.
Tobin’s model with price level and price dynamic
effects
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In our attempt to concentrate on the destabilizing effect of deflation and
flexible prices, we have assumed away the Pigou effect. However, the
Pigou effect must be taken into consideration when price flexibility is
assumed.
Hence again the final determining effect of price flexibility is the
relative strength of the two effects: the price level effects (Keynes and
Pigou effects) and the price change effect or the expected deflation effect.
The second effect as we have seen is operational when the economic
process is occurring in real time which is how things are in reality hence
the importance of the assumption that prices follow a certain trajectory
when the economy is subjected to demand shocks rather than the
assumption of instantaneous price jumps that ensure equilibrium
comparisons between two states of the economy at different prices.
Tobin’s model with price level and price dynamic
effects
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We can construct a formalism that explains the differences according
to the evolution of the state variable of the economy 𝜓𝑡 . Under the
static assumption the economy’s state 𝜓𝑡 does not evolve in time but
takes different values at different times where the states
𝜓1 , 𝜓2 , … … . . , 𝜓𝑛 are produced by instantaneous realizations of
different prices 𝑃1 , 𝑃2 , … … . , 𝑃𝑛 . In the dynamic assumption the state
𝑑𝜓
of the economy evolves under a governing equation of the type
=
𝑑𝑡
𝜓(𝑃, 𝑡) where the states of the economy are 𝜓 𝑃, 𝑡 are solutions to
these dynamic equation.
The stability of the state of the economy is also a resultant of the
governing equation.
Tobin’s model with price level and price dynamic
effects
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
James Tobin has developed a dynamic model that takes into account
the two effects of price level and price changes. The model is a three
dimensional differential equation system whose technical level is
beyond the scope of this book. However, Tobin introduced a
qualitative approach to understanding the model.
The Tobin model posits real aggregate demand as function of the
price level p and expected inflation x E= 𝐸 𝑝, 𝑥 where
𝜕𝐸
𝜕𝑥
𝜕𝐸
𝜕𝑝
< 0 and
> 0. The function E plotted in (x, p) space represent the loci of
combinations of (x, p), 𝐸 ∗ such that the aggregate demand is at a
certain level. Lower 𝐸 ∗ loci represent higher demand. The curvature
of 𝐸 ∗ is the result of the Keynes effect weakening as interest rates fall
and hence the effect of increase in real money balances decline.
Tobin’s model with price level and price dynamic
effects
Suppose initially the economy was in a state 𝜓1 represented by 𝜓1 =
𝜓1 𝐸 = 𝐸1∗ , 𝑝 = 𝑝1 , 𝑥1 = 0, 𝑌1 = 𝑌 ∗ , which says that the level of real aggregate
demand 𝐸1∗ generates full employment output 𝑌 ∗ with the equilibrium price level equals
to 𝑝1 and expected inflation at equilibrium is zero.
Tobin’s model with price level and price dynamic
effects
Suppose now that the economy experiences a negative real demand shock (such as
collapse of MEC) that shifts 𝐸 ∗ that is compatible with 𝑌 ∗ downward to 𝐸2∗ which makes
the old real aggregate demand 𝐸1∗ less than the aggregate demand needed to
generate full employment. Suppose that the p is flexible and is responsible for the
adjustment of the economy to the new full employment state defined by 𝜓2 =
𝜓2 𝐸 = 𝐸2∗ , 𝑝 = 𝑝2 , 𝑥2 = 0, 𝑌2 = 𝑌 ∗ .
Tobin’s model with price level and price dynamic
effects
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There are two ways that this can happen:
1- The New Classical models say that the price instantaneously “jumps” from 𝑝1 to 𝑝2
with no passage of time. Hence instantaneously, we have 𝜓1 → 𝜓2 . This we can call
simultaneous action. This implies that the economy as a system possesses the ability to
adjust with no time lapse between its different states ψ1 , ψ2 , … … . . , ψn . This also
implies that at no time we have
dynamic process.
dp
dt
≠ 0. Hence the transition from ψ1 → ψ2 .is not a
2- The Keynesian solution involves on the contrary the dynamics of price p and price
expectations x which in turn makes the transition 𝜓1 → 𝜓2 .subject to dynamics laws and
𝑑𝜓
hence the state of the economy becomes subject to
= 𝜓 𝑃, 𝑥, 𝑡 . We are not going
𝑑𝑡
to posit again specific dynamic equations for the evolution of 𝜓 but we will discuss
possible time trajectories of 𝜓 as represented in this figure.
Tobin’s model with price level and price dynamic
effects
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Figure NA
Tobin’s model with price level and price dynamic
effects
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Path A will be generated if there is a path of positive inflation and
expected inflation that would push the economy to full employment.
However, this path is highly unlikely as the price movement takes the
wrong direction. Under a negative real aggregate demand, prices
are expected to decline.
Path B will be realized if the Keynes (and Pigou) effect outweigh the
detrimental effects of deflationary expectations. Aggregate demand
recovers and the economy will eventually goes to equilibrium at the
state 𝜓2 = 𝜓2 𝐸 = 𝐸2∗ , 𝑝 = 𝑝2 , 𝑥2 = 0, 𝑌2 = 𝑌 ∗ .
Path C will be realized when deflationary expectations outweigh the
price effects. The economy will veer away from the state 𝜓2 =
𝜓2 𝐸 = 𝐸2∗ , 𝑝 = 𝑝2 , 𝑥2 = 0, 𝑌2 = 𝑌 ∗ and the gap between Y and Y*
increases pushing the economy towards recession and depression.
Price Rigidity for Economic Stability
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We have seen that adverse expectations cause large wage cuts which
may cause hyper deflation but according to Klein “in the real world one
observes neither hyperdeflation nor full employment. The explanation is
that wages are sticky. The solution to the Keynesian system which gives a
value of employment not on the supply schedule persists when wage cuts
do not occur. Because workers do not bid against each other, we do not
experience the hopeless demand spiral.”
Price stability is important to the stability of the capitalist system and
price flexibility thought by the classicals as imparting flexibility to the
capitalist system that ensure the achievement of the full employment
state is wrong.
Tobin said of the centrality of effective demand that “unless a reduction
of the money wage would somehow increase aggregate real demand,
there is no mechanism by whcich the ….” p.4
Keynes’s outline of the Business Cycle
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
In chapter 22 of the GT, Keynes outlined a theory of the business
cycle that is incomplete but attempted to extend the basic insights
gained by the largely static model that aimed at finding the
equilibrium level of output rather than its fluctuations in time which
defines the business cycle in the capitalist economy.
For Keynes, fluctuations in mpc, L(r) and MEC play the major part in
economic fluctuations with the fluctuations in MEC playing the major
part in the business cycle. If we recall the MEC is the discount rate
such that
𝐸𝑥𝑝

𝑃𝑘 =
𝑖 𝑄𝑖
(1+𝑟)𝑖
Keynes’s outline of the Business Cycle
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
Hence the major determinant of the MEC is the current expectations to
the future yield of capital goods. Since these expectations are
precarious, economic crisis or downturn occurs as a result of ‘sudden
collapse of the MEC rather than as a result of the rise of interest
rates.
This happens in the later stages of the boom when optimistic
expectations are strong enough to offset the rising abundance of
capital, rising costs of production and the rise in interest rates that all
occur in the last stages of the boom. A sudden wave of pessimism that
hits investors collapses the MEC.
Keynes’s outline of the Business Cycle


Moreover, as organized markets are made up of ignorant buyers and
speculators, this intensifies the sudden pessimism of market
participants which lead to drop in the value of stock markets. This in
turn leads to a drop in the MEC if the economy experiencing such
events has large “stock-minded” public like the US since the 1920’s
and more economies nowadays.
In addition, the collapse of the MEC leads to uncertainty about the
future which leads to a large increase in the liquidity preference L(r)
which increases interest rates leading to a further drop in investment.
Keynes’s outline of the Business Cycle


Keynes attributed to the uncertainty under which investment is being
done in the capitalist economy to be the main cause of the cycle. He said
“investment is being made in conditions which are unstable and cannot
endure because it is prompted by expectations that are destined to
disappoint.”
Keynes concluded that “In conditions of laissez-faire the avoidance of
wide fluctuations in employment may...prove impossible without a far
reaching change in the psychology of investment markets…I conclude
that the duties of ordering the current volume of investment cannot be
left in private hands.”
Keynes’s outline of the Business Cycle