Lecture Nine: Macroeconomics

1. Lecture Nine: Macroeconomics From “Say’s Law” to … “Emergent Properties”

2. Macroeconomics is… • Micro considers • Behaviour of individuals & firms • Behaviour of markets • Macro considers • The behaviour of the whole economy • And special “markets”: • Labour • Money • And key variables • Rate of employment, growth, inflation… • In the beginning (before Keynes or Walras or even Smith), in Macro there was… • Quite a lot of debate!

3. Mercantilists on Macro • Mercantilism in part justified tariffs, etc., on basis that it would increase employment: • “5. The frugal expending likewise of our own natural wealth might advance much yearly to be exported unto strangers; and if in our rayment we will be prodigal, yet let this be done with our own materials and manufactures, • … where the excess of the rich may be the employment of the poor, whose labours … would be more profitable for the Commonwealth, • if they were done to the use of strangers.” • (Thomas Mun, “England’s Treasure by Forraign Trade. or The Ballance of our Forraign Trade is The Rule of our Treasure”) • i.e., an excess of exports over imports will increase employment…

4. Physiocrats (Quesnay) • The “Tableau Economique” • First ever “input-output” model of whole economy • First systematic attempt to think about relationship between productivity and output at level of whole economy • Basic ideas: • Objective of production to generate a “net surplus” over inputs • Agriculture seen as only source of surplus • Converts free energy of sun into plants, animals • Manufacturing just transforms free gift; no added value • Three classes: • Farmers “the productive class” • Manufacturing workers/firms “the sterile class” • Feudal lords/clerics “the proprietor class

5. Physiocrats (Quesnay) • But manufactures needed to generate rural net product • interdependence (multiplier, input-output concepts) • Agriculture generates a surplus • 1 unit of output requires < 1 unit of input • Sow 1 kilo of wheat as seed, get 10 kilos of wheat as crop • Manufacturing simply converts form • 1 unit of input, 1 unit of output (but in different form) • Surplus key to wealth: Wealth can be increased if gap between inputs and output in agriculture can be increased.

6. Physiocrats (Quesnay) • An example in modern terms: • Old technology with 100 hectares of land: • 1 hectare land + 7/10 bushels wheat + 1/10 kilo steel produces 1 bushel wheat • 0 hectare land + 1/10 bushel wheat + 9/10 kilo steel produces 1 kilo steel • 70 wheat + 10 steel -> 100 wheat • 10 wheat + 90 steel -> 100 steel • Net output 20 bushels wheat, 0 kilos steel

7. Physiocrats (Quesnay) • New technology with 100 hectares of land: • 1/10th less bushels of wheat used: • 1 hectare land + 6/10 bushels wheat + 1/10 kilo steel produces 1 bushel wheat • 0 hectare land + 1/10 bushel wheat + 9/10 kilo steel produces 1 kilo steel • 60 wheat + 10 steel -> 100 wheat • 10 wheat + 90 steel -> 100 steel • Net output 30 bushels wheat, 0 kilos steel • Benefits of improved technology • 16% reduction in inputs (from 7/10ths 6/10ths bushels) • 50% increase in net product (from 20 to 30 bushels) • Means more wealth for “proprietors”, more employment making for workers making “carriages”

8. From Physiocrats to Smith • Smith’s rejected Physiocratic idea that agriculture the only source of wealth: • “Artificers and manufacturers, in particular, whose industry, in the common apprehension of men, increases so much the value of the rude produce of land, are in this system represented as a class of people altogether barren and unproductive” (Wealth of Nations Ch. 9) • But input-output & surplus concepts lost as well… • Smith much less concerned about macroeconomic issues • The big “macroeconomic” debate amongst classical economists was Malthus vs Ricardo…

9. Ricardo vs Malthus • Malthus asserted that • Aggregate demand could be less than supply • A “general glut” • Technological progress could lead to unemployment • Ricardo confident that aggregate demand would always be sufficient: • “Mr. Malthus asks • “how is it possible to suppose that the increased [quantity of] commodities, obtained by the increased number of productive labourers should find purchasers, • without [such] a fall of price as would probably sink their value below the cost of production, or, at least, very greatly diminish both the power and the will to save? “…

10. Ricardo vs Malthus • “To which I [Ricardo] answer that • the power and the will to save will be very greatly diminished, for that must depend upon the share of the produce allotted to the farmer or manufacturer. • But with respect to the other question • where would the commodities find purchasers? • If they were suited to the wants of those who would have the power to purchase them, they could not fail to find purchasers, and that without any fall of price.” • Ricardo, Notes on Malthus' "Principles of Political Economy“ (pp. 160-161) • Ricardo accepted there could be gluts of individual commodities, but not an overall excess of supply over demand:

11. Ricardo vs Malthus • “Mistakes may be made, and commodities not suited to the demand may be produced—of these there may be a glut; • they may not sell at their usual price; • but then this is owing to the mistake, and not to the want of demand for productions. • For every thing produced there must be a proprietor. • Either it is the master, the landlord, or the labourer. • Whoever is possessed of a commodity is necessarily a demander, • either he wishes to consume the commodity himself, and then no purchaser is wanted; • or he wishes to sell it, and purchase some other thing with the money…”

12. Ricardo vs Malthus • Ricardo’s analysis based on “Say’s Law”: supply IS demand • Only reason someone produces something is • to sell it • and buy something of equivalent value • Hence supply is simultaneously demand (maybe with a little lag…) • “Whoever has commodities has the power to consume, and as it suits mankind to divide their employments, individuals will produce one commodity with a view to purchase another;” • Ricardo accepted arguments of Jean Baptiste Say here: • “M. Say has, however, most satisfactorily shown, that there is no amount of capital which may not be employed in a country, because demand is only limited by production.” (Principles, Ch. 21)

13. “Say’s Law” • Say’s Law best put by Say himself: • “Every producer asks for money in exchange for his products, only for the purpose of employing that money again immediately in the purchase of another product; • for we do not consume money, and it is not sought after in ordinary cases to conceal it: • thus, when a producer desires to exchange his product for money, • he may be considered as already asking for the merchandise which he proposes to buy with this money. • It is thus that the producers, though they have all of them the air of demanding money for their goods, do in reality demand merchandise for their merchandise.” • (Say, Catechism of Political Economy)

14. “Say’s Law” • Crises caused by “disproportionality” only • Excess supply in one market, excess demand in others • “General gluts” or “general slumps” impossible • Argument • Money only an intermediary in barter • People sell only to buy again (increase in utility the object) • Each person’s supply is matched to his/her demand • Sum of all supply thus cannot exceed sum of all demand (no “general gluts”); but

15. “Say’s Law” • Slumps in one market can occur if supply of X exceeds demand for X at price producers of X want; however • Unless government regulations, monopolies intervene • Price of X falls, demand for X rises: equilibrium… • Basic logic “micro” in nature • Hypothesis about behaviour of each individual in market system (micro) • Aggregate hypothesis to overall economy (macro) • Argument also essential “real” rather than monetary:

16. Ricardo & Say: the “Odd Couple” • Ricardo accepted Say on macro • But differed on theory of value and price: “Effort is the source of value” • “The value of a commodity … depends on the relative quantity of labour which is necessary for its production” • (Ricardo) “No it ain’t! Utility is…” • “What do you understand by the word Products ? • … all those things to which men have consented to give a value. • How is value given to a thing ? • By giving it utility” • (Say) • “Say’s Law” dominated classical “macroeconomics” (even though neoclassical in origin) until…

17. Marx Debunks Say… • Marx’s “circuits of capital”: C—M—C • “Of the part of the revenue in one branch of production (which produces consumable commodities) which is consumed in the revenue of another branch of production, • it can be said that the demand is equal to its own supply (in so far as production is kept in the right proportion). • It is the same as if each branch itself consumed that part of its revenue. • Here there is only a formal metamorphosis of the commodity: C-M-C' Linen-money-wheat.” (Marx Theories of Surplus Value, 1861 p. 233) • Supply implies demand; aggregate balance the rule…

18. Marx Debunks Say… • But there is also M—C—M+ • “The circuit C-M-C starts with one commodity, and finishes with another, which falls out of circulation and into consumption. • Consumption, the satisfaction of wants, in one word, use-value, is the end and aim. • The circuit M-C-M+, on the contrary, commences with money and ends with money. • Its leading motive, and the goal that attracts it, is therefore mere exchange-value.” (Marx, Capital I 1867, p. 148) • Demand in M—C—M+ can evaporate if expectations of profit collapse…

19. Marx Debunks Say… • Aggregate demand is thus sum of two circuits • C—M—C • Say’s Law applies • M—C—M+ • Say’s Law doesn’t apply • Aggregate demand can therefore differ from aggregate supply • Marx’s logical advance here lost in decline of classical school and rise of neoclassical • Neoclassical school adopts Say’s Law as “Walras’s Law” • “Sum of all excess demands is zero” • No possibility of generalised slump… • Dominates “macroeconomic” thinking before Great Depression

20. Pre-Keynesian Macro • Conventional neoclassical macroeconomic theory less elaborate than Walras’s “General Equilibrium” model: • Assumed fixed capital stock in short run, variable labor supply, etc., rather than “everything variable” as in Walras • Example: Hicks’s “typical classical theory” (outlined in Hicks 1936, “Mr Keynes and the Classics”) • 2 industries: Investment goods X; consumption goods Y • 2 factors of production: labor (variable); capital (fixed in short run) • Given capital stock in both industries:

21. Hicks’s “typical classical theory” • Output a function of employment Nx & Ny • X=fx(Nx); Y=fy(Ny) where f has diminishing marginal productivity • Prices equal marginal costs = marginal product of labour times wage rate (since labour is only variable input): • Marginal cost is increase in labor input (dNx & dNy) for each increment to output (dx & dy) • Px=w.dNx/dx; Py=w.dNy/dy • Income = value of output = price times quantity: • I = Ix + Iy = w.(dNx/dx) .x + w.(dNy/dy) .y

22. Supply I (Interest rate) Demand Ix (output of capital goods) Hicks’s “typical classical theory” • Quantity of Money M a given, and fixed relation between M and income I (transactions demand for money only: money “a veil over barter”): • M = k.I (k constant “velocity of money”) • Demand for investment goods a function of interest rate: • Ix=C(i) • Supply of savingsa function of interest rate: • Ix=S(i) • Higher savings meanshigher investment (a familiar argument?) Determines Nx

23. Hicks’s “typical classical theory” • Causal chain: • M determines I (total output) • i determines Ix (output of investment goods) • Ix determines Nx (given w) • I-Ix determines Iy (output of consumption goods is a residual…) • Iy determines Ny (given w) • Lower money wage means higher employment: • Lower wage means lower prices • Unchanged money I means higher income relative to prices, so higher sales • Higher sales mean increased employment (and lower real wage due to diminishing marginal product)

24. Neoclassical Macro • Asserted unemployment due to excessive wages, until... The Great Depression Arguably began with Stock Market Crash Just one week before…

25. The economists were saying… • “Stock prices have reached what looks like a permanently high plateau. • I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels, such as Mr. Babson has predicted. • I expect to see the stock market a good deal higher than it is today within a few months.” (Irving Fisher, October 15 1929) • In the next few years, Irving Fisher lost12 million dollars! • That’s $102 million in 2000 prices • Crash occurred on October 23rd 1929:

26. A 120 Point Break in just 15 Days... Crash continued for another 3 years:

27. The Great Wall Street Crash and that’s the index; the S&P of 1948 had many stocks which didn’t exist in 1929, while many of the 1929 entrants had gone bankrupt S&P 500 from 32 at its zenith 25 years to recover To below 5at its nadir in less than 3 years Not only theStockmarketcrashed…

28. 10 years to restore output levels 30% fall in output in 4 years The Great Depression WW II

29. The Great Depression To 25% in 3 years WW II Brings Sustained Recovery From effectively zero...

30. Keynes’s “Revolution” • A (partial) rejection of (neo)classical economics • Kept marginal product theory of factor returns; but • Rejected theory of investment, money, savings • Key innovation: proper treatment of uncertainty • Investment: • in certain world, would be determined by interest rate • in uncertain world, motivated by expectations of profit • Expectations of profit volatile & based on flimsy foundations: • Expect current state of affairs to continue; • Trust current prices, etc., as correct • Trust mass sentiment

31. Keynes’s “Revolution”: Investment & Savings • Investment (determined by expectations, output, capital stock) determines income via multiplier • I=f(E,Y,K) (E component highly volatile) • Y=f(I) • Consumption a function of income • C=a + c.Y (stable relationship) • Y=C+I=C+S (ex-post Investment = ex-post Savings) • Savings a residual function of income: • S=Y-C • Investment determines Savings • Attempt to increase Savings (by reducing MPC) may reduce investment & hence output

32. Keynes’s “Revolution”: Money • Neoclassical theory: • money a “veil over barter” • transactions motive only for holding money • Keynes • Money ultimate source of liquidity in uncertain world • Not only transactions, but also speculative, precautionary& finance motives for holding money (latter not in General Theory, but 1937 papers) • Rate of interest the return for foregoing liquidity • Liquidity preference highly volatile because based on expectations (as is Investment)

33. Keynes’s “Revolution”: Critique “Say’s Law” • Expenditure has 2 components: • D1, related to current output (consumption) • D2, not related to current output (investment) • Say’s Law (rejected by Keynes) requires: • either D2=0; or • Increased savings causes increased D2 • But • Decision to invest based on expectations of profit in uncertain future • Increased savings means decreased consumption now • May lead to lower expectations and less investment • Argument inspired by Marx’s C—M—C/M—C—M+, but Marx not cited—probably for political reasons:

34. Keynes’s “Revolution”: Critique “Say’s Law” • “One of the rare occasions in which Keynes praised Marx occurred in a 1933 draft of the General Theory. Here Keynes credits Marx with the • “… pregnant observation … that the nature of production in the actual world is not C—M—C', i.e.. of exchanging commodity (or effort) for money in order to obtain another commodity (or effort). That may be the standpoint of the private consumer. • But it is not the attitude of business, which is a case of M—C—M' , i.e.. of parting with money for commodity (or effort) in order to obtain more money” (1971, Vol. 29, p. 81, Keynes's emphasis). • Dillard 1984 “Keynes and Marx: a centennial appraisal” Journal of Post Keynesian Economics p. 424 • So Keynes’s published critique of Say’s Law not as clear as Marx’s:

35. In a nutshell... • “The theory can be summed up by saying that, given the psychology of the public, the level of output and employment as a whole depends on the amount of investment... • More comprehensively, aggregate output depends on the propensity to hoard, on the policy of the monetary authority as it affects the quantity of money, on the state of confidence concerning the prospective yield of capital-assets, on the propensity to spend and on the social factors which influence the level of the money-wage. • But of these several factors it is those which determine the rate of investment which are most unreliable, since it is they which are influenced by our views of the future about which we know so little.” • Keynes, 1937, “The General Theory…”, p. 221

36. Keynes and Investment under Uncertainty • 1937 papers mark a shift from marginal concepts to “two price levels” • In most of the General Theory, Keynes argued that investment was motivated by relationship between marginal efficiency of investment schedule (MEI) & interest rate • In Chapter 17 of General Theory, “The General Theory of Employment” and “Alternative theories of the rate of interest” (1937), spoke in terms of two price levels • investment motivated by the desire to produce “those assets of which the normal supply-price is less than the demand price” (Keynes 1936: 228) • Demand price determined by prospective yields, depreciation and liquidity preference. • Supply price determined by costs of production

37. Keynes and Investment under Uncertainty • Two price level analysis becomes more dominant subsequent to General Theory: • The scale of production of capital assets “depends, of course, on the relation between their costs of production and the prices which they are expected to realise in the market.” (Keynes 1937a: 217) • MEI analysis akin to view that uncertainty can be reduced “to the same calculable status as that of certainty itself” via a “Benthamite calculus”, • whereas the kind of uncertainty that matters in investment is that about which “there is no scientific basis on which to form any calculable probability whatever. We simply do not know.” (Keynes 1937a: 213, 214)

38. What is “uncertainty”? • Very hard to grasp, even though essential aspect of our world: we do not know the future • But we have worked out how to calculate risk • Most of Keynes’s examples were about how uncertainty is not risk • Negative examples—what uncertainty is not—rather than what it is: • “‘By "uncertain" knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. • The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn….

39. Keynes on Uncertainty • “Or, again, the expectation of life is only slightly uncertain. • Even the weather is only moderately uncertain. • The sense in which I am using the term is that in which • the prospect of a European war is uncertain, • or the price of copper and the rate of interest twenty years hence, • or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. • About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know. • Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability, waiting to be summed.’”

40. What is “uncertainty”? • Imagine you are very attracted to a particular person • This person has accepted invitations from 1 in 5 of the people who have asked him/her out • Does this mean you have a 20% chance of success? • Of course not: • Each experience of sexual attraction is unique • What someone has done in the past with other people is no guide to what he/she will do with you in the future • His/her response is not “risky”; it is uncertain. • Ditto to • individual investments • success/failure of past instances give no guide to present “odds”

41. How to cope with relationship uncertainty? • We try to “find out beforehand” • ask friends—eliminate the uncertainty • We do nothing… • paralysed into inaction • We ask regardless… • compel ourselves into action • We follow conventions • “follow the herd” of the social conventions of our society • “play the game” & hope for the best • So what about investors?

42. Keynes and Investment under Uncertainty • In the midst of incalculable uncertainty, investors form fragile expectations about the future • These are crystallised in the prices they place upon capital asset • These prices are therefore subject to sudden and violent change • with equally sudden and violent consequences for the propensity to invest • Seen in this light, the marginal efficiency of capital is simply the ratio of the yield from an asset to its current demand price, and therefore there is a different “marginal efficiency of capital” for every different level of asset prices (Keynes 1937a: 222)

43. Keynes on Uncertainty and Expectations • Three aspects to expectations formation under true uncertainty • Presumption that “the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto” • Belief that “the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects” • Reliance on mass sentiment: “we endeavour to fall back on the judgment of the rest of the world which is perhaps better informed.” (Keynes 1936: 214) • Fragile basis for expectations formation thus affects prices of financial assets

44. Keynes on Finance Markets • Conventional theory says prices on finance markets reflect net present value capitalisation of expected yields of assets • But, says Keynes, far from being dominated by rational calculation, valuations of finance markets reflect fundamental uncertainty and are driven by whim: • “all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield” (1936: 152) • ignorance • day to day instability • waves of optimism and pessimism • “the third degree”

45. Keynes on Finance Markets • Ignorance due to dispersion of share ownership (shades of Telstra?): • “As a result of the gradual increase in the proportion of equity ... owned by persons who ... have no special knowledge ... of the business... the element of real knowledge in the valuation of investments ... has seriously declined” (1936: 153) • Anyone here got T2 shares?… • Impact of day to day fluctuations • “fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market” (1936: 153-54)

46. Keynes on Finance Markets • Waves of optimism and pessimism • “In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual ... the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.” (1936: 154) • “The Third Degree” • Professional investors further destabilise the market by attempting to anticipate its short term movements and react more quickly • As Geoff Harcourt once remarked, Keynes “writes like an angel”. The next few slides are in Keynes’s own words. Skip Keynes Quotes…

47. Keynes on Finance Markets • “It might have been supposed that competition between expert professionals ... would correct the vagaries of the ignorant individual... However,... these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public... For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.” (1936: 154-55)

48. Keynes on Finance Markets • “Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of most skilled investment today is ‘to beat the gun’, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.” (1936: 155)

49. Keynes on Finance Markets • “professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; ... It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.” (1936: 156)

50. Keynes on Finance Markets • “If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investment on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets.”