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KEYNES AND THE BUSINESS CYCLE

KEYNES AND THE BUSINESS CYCLE INTRODUCTION Economic fluctuations before the 19th century Origin in natural disasters Thought of as being outside human control A “business cycle” as a 19th century phenomenon: why? Increasing specialization, division of labor Increasing industrialization

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KEYNES AND THE BUSINESS CYCLE

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  1. KEYNES AND THE BUSINESS CYCLE

  2. INTRODUCTION • Economic fluctuations before the 19th century • Origin in natural disasters • Thought of as being outside human control • A “business cycle” as a 19th century phenomenon: why? • Increasing specialization, division of labor

  3. Increasing industrialization • Increasing interdependence, and collapse in one sector spreading to other sectors: • Decreasing sales • Layoffs • Lower income • Less spending • A downward cumulative process

  4. A key role for firms: • Production plans, based on expected sales • Hiring plans, based on production plans • And for consumers: • Spending plans, based on expected income • Expected income, based on expected employment

  5. Any role for government in 19th century thought? • Thought to be unnecessary: usually saw eventual recovery without intervention • Could expect small fluctuations in output, but no “general glut”

  6. THE GREAT DEPRESSION The Classical Faith Shattered

  7. Background: the Roaring Twenties • A time of rapid growth, prosperity • Relatively stable prices • Low unemployment-in most sectors • Growth industries: autos; construction; electricity; chemicals • Declining industries: agriculture; railroads; coal

  8. Growing use of consumer credit • Unfamiliar to banks, consumers • Result: overextension • Growing inequality of income; and implications for consumer spending

  9. 1929 and after • Stock market crash, 1929 • Massive wealth loss by 1933: about 80% of stock values gone • Recession beginning in 1929; ordinary through 1930; then the bottom falls out • 25% unemployment rate by 1933; never under 10% in the 30s

  10. Real GDP fell by about 33% by 1933 • 80% of investment disappears, 1929-1933 • Over 40% of banks disappear-and no deposit insurance • Recovery? Not until World War II

  11. What caused it? Why so deep, so long? • Ordinary recession, 1929 • Expectations of normal recovery, 1930 • Massive bank failures • Large decrease in money supply • Deflation

  12. Effects on financial intermediation of deflation: • Decreases in borrower net worth (heavy debt burden) • Increased risk to lenders • Massive disruption of allocation of funds • Investment collapse • Effects long-lasting

  13. Fed fails the test • Concern for maintaining the gold standard • Not serve as lender of last resort • Note 1935-36 contractionary policies • Macroeconomic consequences of financial system failure, especially • Large reductions in money supply • Interference with intermediation process

  14. Decreased consumption, especially consumer durables • Heavy debt burden from 1920s • Uncertainty, due to stock market collapse • Restrictions on international trade: Smoot-Hawley tariff

  15. Political response: the new Deal and its reforms • Monetary: already discussed • Agricultural: already discussed • Industry, and the National Industrial Recovery Act • Goal: Reduce “ruinous competition”

  16. Raising prices to generate higher firm incomes, stimulating hiring-but is this backwards?? • In the end: • Declared unconstitutional • Largely ineffective, in any case • SEC; and securities market regulation • Social Security: an income support mechanism • Public works programs: PWA; WPA; CCC • Goals: recovery; and reform

  17. KEYNES’S CONTRIBUTION • The General Theory of Employment, Interest, and Money as revolutionizing macroeconomics • A response to the perceived failure of classical economics to explain the Depression • Classical Presupposition: Recessions self-correcting via operation of market forces

  18. Key role for wage, price, interest rate flexibility • Say’s Law, and production occurring in order to obtain income for spending • And yet . . .unemployment stayed over 10% in the U. S. for a decade

  19. Keynes’s diagnosis • A potential problem with saving • Primitive society: saving (not consuming) as simultaneously an act of investing (spending) • Industrial society: will my saving automatically find its way into capital accumulation elsewhere in the system? • Classical model: yes, via falling interest rates

  20. Keynes: maybe not, as investment occurs in response to favorable profit prospects • Further: investment is volatile, uncertain; strongly affected by changeable expectations • Implication: some of income created by production process not necessarily find its way into new spending

  21. Overall problem: may be thought of as a coordination failure • Some initial shock decreases spending • Firms constrained from hiring workers • Incomes fall • Households constrained from buying goods • Problem: who moves first to break the deadlock?

  22. A new framework: aggregate demand/aggregate supply analysis • Aggregate demand • A way to talk about people’s spending plans in the aggregate • Components: • Consumption • Investment

  23. Government spending on goods and services • Net exports (= exports - imports) • Aggregate supply: firms’ willingness to produce and sell output • Economy-wide equilibrium: occurs when AD = AS

  24. The Great Depression? A collapse of aggregate demand • Causes of such collapse? Still unclear! But emphases on a variety of possibilities • Downward cumulative process worsened significantly by collapse of financial system, international trade

  25. Policy implications of the General Theory: include a role for government in stabilizing the economy • Monetary policy, and the central bank • Fiscal policy • Changes in government budget: taxes; spending • May involve government deficits-which are not necessarily bad

  26. If aggregate demand too low, could be raised by • Tax cuts • Increased government spending • Expansionary monetary policy (open-market purchases) • If aggregate demand too high, do the opposite • Was fiscal policy appropriate during the Depression? • No: scale too small • Depression ended during wartime: is war, then, good for the economy after all? No . . .

  27. SUMMARY • Keynes as changing the nature of the macroeconomic debate • What’s left of his analysis? • Focus on • Aggregate demand as driving short-run fluctuations in economic activity • Volatility of expectations, hence investment (and perhaps other) spending

  28. In the long run, the economy may well adjust automatically to full employment-but it may take considerable time • Thus, there may be a role for stabilization policy on government’s part • Form of stabilization policy is still controversial, as is the speed of adjustment to full employment

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