History of Economic Doctrines

Lecture 33

Keynesian Economics and the Economics of Keynes

 

John Maynard Keynes and the Great Depression [ Keynes Bio Link ]

 

-Monetarists’ vs. Keynesians

 

Monetarists:                                          

Keynesians

AD depends on money supply

AD = C+I+G+X-M

 

Keynes Belief:

-An Increase in aggregate demand at full employment led to an increase in the price level.

-Also that a decrease in aggregate demand would lead to a quantity adjustment in which producers decreased production (Keynes thought that, in a recession, people would only produce if they thought that someone would buy the goods that they produced.)

            -Demand creates its own Supply\

 

Neoclassical Macro v. Keynesian Theory

 

Neoclassical
The market is a machine that generates “the best of all possible worlds.” [to quote Dr. Pangloss, from Voltaire’s Candide.]

- Assumes flexible w, i , p and Say’s Law

            -- yields full employment

- AD just determines price levels

            -- price levels determined by the money supply: D M/ M à D P/ P

 

Keynes

- Neoclassical paradigm is not valid in the SR when AD falls because of sticky wages and prices

 Quantity Adjustments

Similar Debates

 

Price Adjustments to Disequilibria

Quantity Adjustments to Disequilibria

Joseph Bertrand duopoly model

Cournot duopoly model

Leon Walras’ “tátonnemènt equilibration

Alfred Marshall partial equilibrium models

Classical/neoclassical macroeconomics

John Maynard Keynes

.- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -

English classical : Supply à Prices [labour theory]

Austrian: Demand à Prices [subjective]

 

-Keynesian Theory

 

Keynes thought that a capitalist economy would experience high unemployment as a long term situation unless some external forces were used to reduce it.  He believed that this external force must come from government and should take the form of large expenditures on public works projects capable of utilizing and mobilizing willing workers who are unemployed.  Keynes did not believe in the long tradition of “laissez-faire’ policies, which strongly discourage government intervention in the economy.

 

1. Keynesian theory accepts the classical and neoclassical theory that flexible wages, interest rates and prices, combined with Say’s Law, ensure full employment and a maximum value for output in the long run.  But Keynes famously wrote, “but in the long run we are all dead.”

 

2. Keynesian theory concludes that, in the depths of a deep depression or recession, “demand creates its own supply.”  This is in contrast to Say’s Law, with states that “supply creates its own demand.”

 

3. Keynesian Aggregate Expenditures are the sum of: C+I+G+ (X-M) as these planned spending relate to income

 

4. Keynesian theory suggests that, during severe depressions, excessive unemployment can be reduced by increases in government purchases

 

5. The Great Depression finally ended when the U.S. government entered World War II

 

6. Keynes theorized that the demand for money depends on the prevailing interest rate and expectations about economic conditions.  This notion is known as liquidity preference

 

7. The Keynesian concept of ‘sticky wages’ and interest rates turns neoclassical macroeconomics on its head

 

8. Keynes’s precautionary demand for money states that we have cash on hand because cash is needed to purchase goods or services not planned for

 

-Money is:

1.      Medium of exchange,

2.      Standard measure of value

3.      Store of value- this idea is distinctly Keynesian

4.      Standard of deferred payment

-precautionary

-speculative (assets)

Money as an asset: liquidity preference

 

Bond example:

 

PV = A

        ----

           I

 

-If interest rates are expected to go up, then people would not want to buy bonds.

 

Keynesian Multipliers and Fiscal Policy

 

-Aggregate Demand

 

AD= C + I + G + XZ-M

 

Demand creates its own supply

 

If AD falls, it won’t be a price adjustment (classical and neoclassical thought), but a quantity adjustment

 

Savers and investors are very different people with different motives.

            -savers may save for a rainy day or save in order to consume at a later date

-this means that an increase in saving does not necessarily translate to an increase in investment

 

In a recession you can’t count on investors to bail the economy out (they won’t invest when people aren’t consuming); therefore, you need government spending to lift the economy out of a recession.

 

          n

PV = ∑                            AE

            T=1                  ------------

                                               T

                                       (1+i)

 

-Theory of rational expectations: no one can make money except by accident.

 

 

MD                                    

----   = f (wealth, r, i, i, h, e, (p)

  P                            b

 

-Monetary Theory

-Added an enormous amount to monetarist theory

-Added concept of velocity preventing economy from reaching full employment.

-Fiscal policy: way of injecting money into system.

-Attempting to increase AD by increasing money supply and velocity.

-Modern Monetarism – Considered to be generally derived from Keynes’ 1936 work The General Theory of Employment, Interest and Money. Subject of debate as to whether money affects prices or output.

 

MV =PQ

 

-Quantity Theory of Money

 

Cambridge equation: MD = KPQ

 

 

-Under the classical theory: if one holds $, then one gives up the right to alternative uses of the money.

 

Figure 32-2

   

                            

 -Economics of AD

 -If the economy starts at full employment at point a, an increase in Aggregate Demand (AD2) will cause prices to rise proportionally. But a decrease in Aggregate Demand (AD1) will result in quantity adjustments, to point b. The economy will be in a depression at output Q0.

-The red segment corresponds to short run Keynesian Aggregate Supply during depressed times.

 

 

 

 

 

 

Liquidity Preference

            -Inversely proportional relationship between interest rates and bonds

-As i decrease, prices of bonds increase

Criticisms of Neoclassical

Assumes velocity and quantity are fixed

 -BUT:

-spending is a function of expectations

-expectations of a reality cause that reality to unfold (helps explain Depression/Inflation)

** How do the foundations for your pessimistic/optimistic expectations determine the change in your spending?


- Assumes hardcore analysis and independent reason, and ignores herd behavior of investors

 

-W, I & P Sticky

 

Wage Rate & Sticky Prices
1940’s –1970’s Keynesian paradigm reined
            -prices adjust much faster than wages; wage rate is the stickiest set of prices

-p > i > w
Example: 9-11 attacks
            - Fed increased money supply because it expected output to decrease

-the recession worsened: velocity of money went down as money supply rose

-anything that reduces spending/buying tends to reduce inflation

 

Reasons for Wage Stickiness

1        Goods in spot markets, wages by contract

2        Cut wages à people riot

3        Peak-end rule (Kahneman & Tversky)
- it’s NOT where you are that matters, but where you were

4        Efficiency Wage
- firms pay workers above the opportunity cost of their next best alternative to ensure diligence
-quality is a function of price
-wages would be more flexible at the lower equilibrium wage

 

Lerner Wage-Price Reaction Functions

Keynesian Quantity Adjustment vs. Instantaneous Price Adjustments

 

- the more out of whack a market is, the faster the rate of adjustment that takes place
            -- extreme surpluses (excess supply): high decrease in prices
            -- extreme shortages (excess demand): high increase in prices
- markets adjust more easily to excess demand (increasing prices) than to excess supply (decreasing prices) à prices go up easier than they go down
- prices adjust up/down faster than wages do
            -- longer sticky unemployment: goods sold in spot markets, labor by contract

 

-Velocity Effect

 

M + V = P + Q

 

M ↑ 5%, V 5%, no effect on P and Q.

 

Perpetual of dynamic disequilibrium

Objection: if everything is cause and affect then the notion of dynamic disequilibrium does not exist.

 

-Great Depression:

 

Banks will not make loans à M ↓, and people who do receive money choose to save it, but not in the bank, thus further reducing the money supply. 

 

Keynes solution: find a way to boost AD.

 

 

"[Monetarism] has benefited much from Keynes' work...If Keynes was alive today, he would no doubt be at the forefront of the counter-revolution. You must never judge a master by his disciples."                                                              -Friedman

 

 

 

Figure 32-4  Keynesian Quantity Adjustments

 

-Government Intervention

 

Believed that the invisible hand may be too slow. Government intervention was thus necessary. 

*    Aggregate Expenditure = C + I + G + (X-M)

*    During recession, we cannot count on consumption to rise since people tend to save more than spend. People are afraid seeing others around them without a job.

*    Investment will also not rise since investors are unsure if their investments will give them the returns since people are not buying. 

*    Trade does not change since any activities to limit import could start trade wars and thus effectively reducing trade benefits

*    Government spending is the only thing that can rise to get the AE back to its original point.  One big problem, however, is that once government starts spending more it is hard for them to cut back. 

*    Keynes believed that capitalism leads to disparities in income distribution

                                    -this inequality leads to depressions

-governments will use imperialistic wars as mechanisms to get out of recessions/depressions

 

Government Intervention History:

-Smoot- Hawley tariff passed in 1930 set the highest tariffs in US history

            -other countries retaliated by increasing their tariffs on US goods

            -lead to severe worldwide losses of the gains from international trade

-US adopted these suggestions during the New Deal

-Great Depression ended when the US entered WWII

-Keynes believed that unfair reparations placed on Germany after WWI would lead to the next world war; he was correct.

 

Ralph Byrns proposes an Easter Egg Hunt (the eggs will be stuffed with money) as a substitute for wars

-demonstrates that wars are not needed for Keynesian multipliers to work theoretically.

-problem with Keynesian multipliers is that government spending is addictive

 

Criticism or Alternatives to Government Spending

 

Argument against Keynesian “cure”:

-after recession ends, government spending remains the same until next recession when spending goes up again

 

One alternative to increasing government spending is lowering taxes

            -decreased taxes means that people spend more

            -may not work in a deep recession if people are too pessimistic

            -this is a demand side argument for cutting taxes

            -the previously discussed Laffer curve is a supply side argument for cutting taxes

 

-Other Ideas:

 

Paradox of Thrift

-people’s attempts to save more may lead them to saving less because increased savings can lead to decreased investment

-recession or depression may result from this decreased investment and subsequently people will make less money, leading to decreased savings

 

 

These web pages are significantly edited and elaborated versions of student notes based on lectures by Ralph Byrns, 2002-2005.